Lost Collateral on Secured Loan

You seem to meet all the qualifications for a non-business bad debt:

1. You have a legal obligation to pay the debt
2. The assets are worthless

Take the $166 bad debt as a deduction the year the creditor collects.

Jim Hammond, EA

Another qualification of non-business bad debt is that it must not arise in connection with your trade or business.

It looks like a business is involved here. Non business bad debt does not make sense to me. Looks like investing capital, and losing your investment. Non business bad debt is deductible on Schedule D as a short term loss, but an investment loss is deductible as a short or long term loss on Schedule D.

While the money was put up as collateral to facilitate a business loan

- that is now in default - it is not my business to be making loans. As a practical matter, especially since I will have neither $166K in short term nor long term losses this tax year (2011), the net difference seems to matter little.

previously

I agree that this is a NON-business bad debt because it was not a business operated by the taxpayer who has lost his investment.

But you're an investor. I don't see this as being different from buying stocks/bonds and selling it for a loss.

It matter because if it's a long term loss then the carryover is a long term carryover. It will be balanced against long term gains first.

There are 3 possibilities:

- Either the original person made an investment.

- Or the person gave money to his son who then made an investment, in which gift tax considerations are involved

Just to clarify on this last point. I put money as collateral for a loan made by a bank to Bad Latitude - an LLC - which my son-in-law was one of three partners. Bad Latitude used the proceeds of the loan to open a restaurant - which was in business for almost 3 years before it went out of business. Bad Latitude had paid down the loan to the bank somewhat, but after going out of business, have defaulted on the remaining balance of the loan.

I have to wonder if you were to obtain any benefit from providing the collateral. Any interest to be paid to you? A share of the profits? A share of the business? Or was this just to help your son? Who were the other investors in the LLC?

snipped a LOT

I've been following this post but hadn't yet responded due to time constraints. I'm still under those constraints but I see this moving in what I consider the wrong direction so I want to jump in.

The OP put up collateral for a loan. The borrower defaulted, the collateral was forfeit. The person who put up the collateral was not involved in the business and wants to know what recourse they have.

I'm not sure you have any recourse at all, likely not even a tax deduction. To get a tax deduction you have to have engaged in some sort of taxable type of transaction.

Did you loan money to the LLC, NO! If you had you'd have a note, which the IRS would expect you to attempt to enforce before you took a deduction.

Did you buy an interest in the LLC, NO! If you had, you'd be listed on the returns as an owner and you'd get a K-1. You'd also be able to write off your investment in the LLC as worthless.

Did you loan your son money? Probably not, at least not from what I read. If you had you would still be expected to attempt collection. Whether you'd want to pursue legal actions against your son or not I can't say.

The question I need to ask you is this - do you have ANY documents in place with anyone about you putting up the collateral OR did you simply do it as a favor to your son?

What may be worse yet is that it is possible that you losing the collateral to the bank COULD result in a deemed gift to your son. You may have a gift tax return due as a result of what you did.

This is why its important to work with a professional BEFORE you do something. We may not like what you want to do and may advise against it, but most of us can find a way to help protect your interest in the event things go south. What we can't do is fix somethings after the fact, especially once the year for the activity has closed.

Sorry, Gene E. Utterback, EA, RFC, ABA

your points are very good, but I would add that maybe (what do those documents say?) the loss of the collateral CREATES a loan to the LLC, which efforts can be made to have repaid. Lots of luck on that, but at least this scenario creates a loan to be written off.

With all due respect to my esteemed colleague, Pico Rico, and with the caveat that if you ask 100 enlightened and educated professionals a question you can easily get 101 legitimate responses -

I DISAGREE - I do not see the loss of collateral as creating a loan to the LLC. Additionally, even if it did, there is no way to attempt collection from an already defunct entity. And with the related party issues documentation is very important in supporting any position taken that results in a tax benefit and nothing I've seen indicates that there is any documentation of any sort.

In my never humble opinion (yes, I spelled it out for impact) I think this created a gift to the son and a gift return is due.

Gene E. Utterback, EA, RFC, ABA

Suppose the LLC had merely decided not to pay, and the bank collected the collateral. Wouldn't the guarantor then be able to collect from the LLC? These events might not have created a loan, but they do seem to have created a debt.

That just makes the debt uncollectible.

There has to be some else the lender couldn't have collected the collateral.

Seth

The loss of collateral could also create a GIFT to the LLC if the owner of the collateral has no recourse against the LLC for recovery.

Don't make assumptions. If you want a correct answer, give us ALL the facts.

ok, we disagree.

Additionally, even if it did, there is no way to attempt collection

yes, we agree. That would have no bearing on whether this is the creation of a loan.

And with the related party issues

That may very well be, as I indicated when I said "what do those documents day?".

However, I think it is worth considering if in this case the loss of collateral creates a loan. I would imagine that in a normal situation that would be the case. For example where there is proper documentation and the person providing the collateral participated in the business or its ownership. I think there were a lot of good "issue spotting" responses, including yours. How these spotted issues play out in this particular situation depends on the facts, of which we have relatively few.

SNIPPED

And this is the crux of my position - documentation. No documentation between the person who put up the collateral and ANYONE else, not the son, not the LLC, not the bank, not anyone as near as I could tell from the OP.

And you have hit the nail on the head with your last sentence - we have relatively few facts on which to make an educated guess.

One of the things that I have always liked about this NG, and NGs like this in general, is that they are a GREAT place to get help making sure you haven't overlooked something, what some might call "thinking outside the box." But the biggest fear I have for those who come here is that the information they get from the responders (you and me and the others) is a suitable substitute for professional assistance, and it isn't - not even from me a licensed tax professional with almost 30-years experience.

The purpose of my post was to point out to the OP that not only might he not get the treatment he was looking for, a tax deduction, but he might be in for a little "salt in his wound" by having his collateral considered a gift, especially in the absence of any documentation and most especially when he engaged in a related party transaction.

As much as I'd like to HOPE he can call it an undocumented loan and get some preferential tax treatment, I would be remiss if I failed to point out to him that he may be in a much less favorable position than he had originally considered.

Gene E. Utterback, EA, RFC, ABA