Worthless Loan-Non-business bad debt

[Sakthi]

IRC Section 6511 allows 7 year statute for worthless loan/debt.

1. I have a new client, who loaned 30,000 in 2002 and the borrower filed bankruptcy in 2007. They settled the case and the client said that he collected 10,000. He also said that he did not claim any bad debt for the uncollected 20,000 in 2007 or in any of the following years. The client is asking whether he could claim the loss in 2014. The proper way to handle this, I believe, is to file an amended return for 2007 under the 7 year statute. I would like some input and suggestions from the community.

2. If we file the amended return for 2007, and if the client did not have any capital gains to absorb the non-business bad debt, what do we do? Do we file amended returns for 2008 and the following years? I did not see any research materials I looked at, address this issue.

I would really appreciate your suggestions and comments. Thanks.

[Roland Slugg]

You are correct. The statue of limitations for filing a refund claim or an amended return to report a loss arising from a bad debt (or worthless securities) is seven years instead of the usual three years. (Code §6511(d)(1)) However, just because the borrower filed bankruptcy in 2007 that does not necessarily prove that the debt became worthless in 2007. It may have become worthless in 2006 or in any other year back to 2002.

Assuming it did become worthless in 2007, your client should file an amended return for the year 2007, and that return must be filed NLT April 15, 2015. A non-business bad debt is automatically treated as a LTCL, so if the T/P had no other capital gains (and you said in your post that he didn't), then he can deduct $3,000 of the loss in 2007 ... assuming he did have some taxable income. The remaining loss gets carried over with up to $3,000 of it deductible each year if it's not offset by other capital gains. This will continue every year until it's used up or offset by capital gains in a future year or years. Accordingly, if the loss isn't absorbed in full in 2007, he should file amended returns for 2008, 2009, 2010 and so on .... as long as some of the unused carryover remains.

The IRS people who process such amended returns are not good at handling this situation, and your client's amended returns may be rejected as being filed after the statute of limitations has expired. If that happens, the best course of action would probably be to contact the taxpayer's advocate office within the IRS and explain the situation. To head this off, however, I recommend that the amended returns all be filed together, as a group, and that an appropriate transmittal letter be attached explaining that the "enclosed" amended returns are being filed pursuant to the 7-year SOL as provided by Code §6511(d)(1).

Good luck with this.

[Sakthi]

You are correct. The statue of limitations for filing a refund claim or an amended return to report a loss arising from a bad debt (or worthless securities) is seven years instead of the usual three years. (Code §6511(d)(1)) However, just because the borrower filed bankruptcy in 2007 that does not necessarily prove that the debt became worthless in 2007. It may have become worthless in 2006 or in any other year back to 2002.

Assuming it did become worthless in 2007, your client should file an amended return for the year 2007, and that return must be filed NLT April 15, 2015. A non-business bad debt is automatically treated as a LTCL, so if the T/P had no other capital gains (and you said in your post that he didn't), then he can deduct $3,000 of the loss in 2007 ... assuming he did have some taxable income. The remaining loss gets carried over with up to $3,000 of it deductible each year if it's not offset by other capital gains. This will continue every year until it's used up or offset by capital gains in a future year or years. Accordingly, if the loss isn't absorbed in full in 2007, he should file amended returns for 2008, 2009, 2010 and so on .... as long as some of the unused carryover remains.

The IRS people who process such amended returns are not good at handling this situation, and your client's amended returns may be rejected as being filed after the statute of limitations has expired. If that happens, the best course of action would probably be to contact the taxpayer's advocate office within the IRS and explain the situation. To head this off, however, I recommend that the amended returns all be filed together, as a group, and that an appropriate transmittal letter be attached explaining that the "enclosed" amended returns are being filed pursuant to the 7-year SOL as provided by Code §6511(d)(1).

Good luck with this.

Thank you for your reply Mr. Roland Slugg. I checked with my client about any capital gains he reported in 2007. According to him, he had excess capital losses in 2007 and he deducted $3000 in that year. Since he has capital losses carryover amount in this year also, I assume that his capital losses might have exceeded any capital gains in all these years. I agree that sending amended returns for all these 7 back years will raise questions. Thanks for the suggestion to contact the taxpayer's advocate office, if needed. By filing all these amended returns, he will correct his carryover losses and it will be higher than what is reported now. I hope it is worth the time to do this. If you have any comments on this, please reply.