Dear Rick:
I have a tax problem that I hope you can help me with. Last year I met a couple through my church in desperate need. They had lost their home and had no money for food and clothes for their children. I helped out by giving them money as well as loaning them some money. Nothing was put in writing about the loan, as I thought they were trustworthy and would pay the money back. I had a conversation with my tax person, and to my shock he told me that I was not entitled to a charitable contribution for the money I gave them. I trust my tax person but I want a second opinion. Do you think I’m entitled to a charitable contribution? My next question deals with the loan. They were supposed to begin repaying the loan in January, but when I contacted them they claimed it was not a loan but a gift and thus, they have no intention to pay the money back. I was told by a friend that I potentially can write the debt off as a bad debt. Once again, my tax person disagrees with that. What are your thoughts?

Thanks.
Tammy

Dear Tammy:
With regard to the charitable contribution deduction, I agree with your tax preparer. In order to qualify for a charitable contribution the money must have been given to a charitable organization. Unfortunately, you gave the money directly to the individual which under our tax law does not qualify for a charitable contribution deduction, even if the person was in need . Therefore, I believe the tax preparer is 100 percent correct.

With regard to the money that you loaned the couple, it is questionable at best that you can claim that amount as a bad debt. Under our tax laws, you are allowed to deduct bad debts, within limits; however, you as the taxpayer would have the burden to prove that the money was actually a loan as opposed to a gift. This is a difficult burden since nothing was put in writing about the debt. In addition, what hurts you is the fact that you did gift them other money. Therefore, it is logical to presume that unless there was something in writing, that all the money given was a gift.

There is also another issue with regard to the bad debt that weighs against you. In order to claim a bad debt deduction, you have to document efforts to collect the debt. The IRS has held that in many situations that burden includes bringing legal action against the debtor. In the situation at hand, your only collection effort was the phone call, and I’m confident the IRS would conclude that that is not sufficient. Therefore, in my opinion without more, the IRS would deny your bad debt deduction.

It is important that when you loan money to an individual you have some sort of documentation. People always think that if you document a loan to a family member or a friend that means you don’t trust them. As I have said in the past, it has nothing to do with trust. After all, why would you loan money to someone you don’t trust? The reason you have things in writing is that so both parties understand what they’re getting involved in. After all, when you enter into a loan, at a minimum both parties should know if the loan has any interest and what the repayment schedule is. When you don’t have things in writing, it opens the door for more problems. Therefore, if you ever loan money to anyone, make sure you have some documentation.

Good luck!

Rick is a fee-only financial advisor. His website is www.bloomassetmanagement.com. If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com