In the world of finance and investing, making loans is often seen as a relatively safe way to earn a higher rate of return than other investment opportunities. For many individuals, this means venturing into the realm of real estate loans, where they can use their expertise to evaluate the merit of investment opportunities and lend money to interested parties from their personal accounts.
While these types of loans often come with the benefit of being entitled to a bad debt deduction if they are not repaid, what happens when an individual ventures beyond real estate loans and makes a single non-real estate loan that goes bad? Does the taxpayer still have the right to claim a bad debt deduction in this situation? The court addressed this question in Bercy v. Commissioner, T.C. Memo. 2019-118, and the ruling provides insight into how the IRS views these types of loan situations.
Facts & Procedural History
The taxpayer was a real estate broker. He operated a business that made mortgage loans secured by real estate. Separate from this, he made similar loans from his personal account. This dispute involves the loans from his personal account.
The taxpayer made a loan from his personal account to a specialty furniture manufacturer. The loan was documented in a promissory note, etc. After making the loan, the furniture store’s sales declined and it defaulted on the note.
The owner of the furniture store started looking for a buyer so it could pay off the taxpayer’s loan and prior loans it had received.
A buyer was eventually found and the taxpayer was assigned a partial interest in the promissory note with the new owner of the furniture store. The new note only resulted in a partial recovery of the balance of the original note. The new owner of the furniture store made the monthly payments under the new note and then paid it off early.
The taxpayer reported a bad debt deduction on his individual income tax return for the loss. The IRS audited the tax return and disallowed the loss.
Tax Loss for Bad Debts
Bad debts are often the subject of IRS audits. The IRS selects tax returns for audit by looking for “large, unusual or questionable” items. This translates to large one-time changes reported on tax returns, such as tax losses.
Bad debts are deductible in the year the debt becomes wholly or partially worthless. If it is a business debt, taxpayers deduct this loss against their ordinary income.
If it is not a business bad debt held by an individual, the taxpayer deducts the loss against their capital gains. The loss is treated as a short-term loss that offsets short-term capital gains. This can limit the taxpayer’s ability to take advantage of the tax loss, which is why the IRS typically argues that loans made by individuals are non-business loans. Advanced tax planning can help avoid these disputes.
The Trade or Business of Making Loans
Whether a debt is a business or non-business depends on what trade or business the taxpayer was in and whether the loan was related to that business.
An activity of making loans to others can count as being in a lender. Being a lender can be a separate trade or business. With lenders, it would seem that any loan they made would be related to their trade or business–right? The IRS didn’t think so in this case.
In this case, the IRS agreed that the taxpayer was in the trade or business of making loans. But it argued that the taxpayer in his personal capacity was in the business of making real estate loans. The argument continues that this loan was to a furniture store and, therefore, not related to the taxpayer’s personal trade or business of making real estate loans.
The tax court did not agree with the IRS. It noted:
We are not persuaded to construe the term “trade or business” so narrowly in this context. When previously considering the status of loans as “business debts” under section 166, we have not segmented the taxpayer’s lending business according to the nature of the loan or type of customer. Rather, we have simply asked whether the taxpayer was in the business of lending money, separate and distinct from any other gainful employment he or she may have had.
The court found for the taxpayer, concluding that the bad debt deduction offset his ordinary income. It was not limited to his short-term capital gains. It also agreed that tax penalties were not owed.
Those Who Venture Beyond Real Estate Loans
It is common for those in the real estate lending business to make loans from their personal accounts. They do this as they regularly come across investment opportunities and those wanting funds and have the expertise to evaluate the merits of these opportunities. They also see it as a relatively risk-free way to earn a higher rate of return than afforded by the stock market. But lending money is risky.
This stands for the proposition that real estate and non-real estate loans are viewed as one in determining whether a bad debt deduction is allowable for the individual taxpayer. This should provide some comfort to real estate lenders who venture beyond real estate in making loans.
This court case confirms that a taxpayer who regularly makes real estate loans from their personal accounts is entitled to a bad debt deduction for loans that are not repaid. But what if the taxpayer ventures beyond real estate loans and makes a single non-real estate loan? This case clarifies that the type of loan does not matter as long as the taxpayer is in the trade or business of lending money, separate and distinct from any other gainful employment they may have had. This case provides some comfort to real estate lenders who venture beyond real estate in making loans, as they can rely on the same principles to claim a bad debt deduction. Taxpayers should seek professional tax advice and engage in advanced tax planning to minimize the risks associated with lending money and to avoid any disputes with the IRS.