What if You Default

There are few things that hurt family relations more than bad debts. But the IRS is not ashamed to get involved. If your lender tries to write off your bad debt on his tax return, the IRS will then seek to collect the lost tax from you. Think it won't happen? Well, a 1995 U.S. Tax Court case tells the story of a father who made thousands of dollars in undocumented loans to his 23-year-old daughter, who wanted to open a roller-skating rink.

The skating rink eventually failed, and the father claimed a $35,000 nonbusiness bad-debt deduction, even though no formal collection efforts were undertaken against his daughter. (She had filed for bankruptcy four months earlier.) The Tax Court concluded that the advances were loans because of "loan" notations the father had made on some of the checks, and because he had previously made undocumented loans to family members and friends and had been repaid.