Can I Write Off a Loan to a Family Member? Bad Debt Rules

You can write off a loan to a family member on your federal taxes, but only after two things are true: the transfer was a genuine loan rather than a gift, and the borrower is now completely unable to repay you. When both conditions are met, the IRS treats the unpaid balance as a nonbusiness bad debt and lets you claim it as a short-term capital loss.¹ The catch is that the IRS starts from the assumption that money moving between relatives is a gift, and you have to overcome that presumption with documentation and behavior that looks like arm’s-length lending.

What Counts as a Real Loan

Section 166 of the tax code allows a bad debt deduction only for a bona fide debt: a genuine debtor-creditor relationship with a real obligation to repay a fixed sum.² If you handed the money over with the understanding that repayment was optional, the IRS treats the transfer as a gift and no deduction is available.¹

The strongest piece of proof is a written promissory note signed at or before the time the money changes hands. A useful note contains the principal amount, an interest rate at or above the Applicable Federal Rate, a repayment schedule with specific due dates, a default clause (often an acceleration provision that makes the whole balance due on a missed payment), and signatures from both sides. A notary acknowledgment adds weight.

Paperwork alone is not enough. Courts and the IRS also ask whether the borrower had a realistic ability to repay when you made the loan, and whether you actually acted like a creditor afterward. Sending payment reminders, keeping records of what has been paid, charging the interest the note calls for, and pursuing missed payments all support the loan characterization. Lending a large sum to a relative with no income and no plan for repayment, then never asking about it, looks like a gift no matter what the note says.

Interest You Have to Charge

A family loan should carry interest at or above the Applicable Federal Rate for the loan’s term. The IRS publishes AFRs monthly in three tiers: short-term for loans of three years or less, mid-term for loans over three and up to nine years, and long-term for loans longer than nine years.³⁴

Charge less than the AFR, or nothing at all, and the below-market loan rules kick in. The IRS treats the shortfall as “forgone interest” that you gifted to the borrower and that the borrower then paid back to you as interest income, which means you can owe tax on interest you never actually collected.⁵

Two exceptions soften this for smaller loans. If your total outstanding balance to one person is $10,000 or less, the imputed interest rules do not apply, provided the borrower did not use the money to buy income-producing assets. For balances between $10,001 and $100,000, the imputed interest you have to report is capped at the borrower’s actual net investment income for the year, and if that net investment income is $1,000 or less it counts as zero.⁵ Once the balance passes $100,000, the exception disappears.

When the Debt Is Worthless Enough to Deduct

Even a well-documented loan produces no deduction until the debt becomes totally worthless. Nonbusiness bad debts do not qualify for partial write-offs; the borrower must be completely unable to repay.²

You need to show reasonable collection efforts before concluding the debt is dead. Useful evidence includes written demands for payment, use of a collection agency or attorney, a bankruptcy discharge of the borrower’s debts, or documentation that the borrower is insolvent with debts exceeding assets.⁶ Filing a lawsuit is not always required. If you can show a judgment would be uncollectible because the borrower has no income and no property, that generally suffices.

Getting the Year Right

The deduction has to be claimed in the exact tax year the debt became worthless, not earlier and not later.² That usually means identifying a triggering event: the borrower’s bankruptcy filing, the loss of their only income, or the discovery of insolvency. Waiting to claim the loss in a later year when your income is higher does not work; the IRS can disallow the deduction on the ground that worthlessness happened earlier.

If you find out you missed the right year, the statute of limitations for bad debt deductions is seven years from the original filing deadline, not the usual three, so you have room to file an amended return for the correct year.⁷

How Much You Can Actually Deduct

A worthless family loan is a nonbusiness bad debt, which the tax code treats as a short-term capital loss no matter how long the loan was outstanding.¹ That classification controls how quickly you can use it.

The loss first offsets any capital gains you have for the year. After that, you can deduct up to $3,000 of the remaining loss against ordinary income, or $1,500 if you are married filing separately.⁸ Anything left over carries forward to future years as a short-term capital loss and keeps carrying forward until it is used up.⁹ A large family loan can take years to fully absorb, which is slower than a business bad debt (deductible in full against ordinary income) but still reduces your tax bill over time.

How to Report It on Your Return

Reporting a worthless family loan touches three parts of the federal return.

On Form 8949, Part I, enter the bad debt as a short-term capital loss. Put the borrower’s name in the description, use the date you made the loan as the acquisition date and the date the debt became worthless as the sale date, list the unpaid principal as your cost basis, and enter zero as the proceeds. Transfer the totals from Form 8949 to Schedule D, where your overall capital gain or loss for the year is calculated.¹⁰

Attach a separate statement to the return. The IRS wants four things spelled out: a description of the debt including the amount and when it came due, the borrower’s name and your relationship, the collection steps you took, and the basis for concluding the debt is worthless.¹ Specifics beat generalities. Dates of demand letters, a copy of a bankruptcy notice, or a summary of the borrower’s financial condition carry more weight than a claim that the borrower “couldn’t pay.”

If the IRS Calls It a Gift Instead

When the IRS decides that what you called a loan was really a gift, because the terms were too loose, no interest was charged, or you never tried to collect, the bad debt deduction disappears. The reclassification can also trigger gift tax reporting.

For 2026, you can give up to $19,000 per recipient per year with no gift tax filing at all.¹¹ If the recharacterized amount exceeds that annual exclusion, you have to file Form 709 for the year of the transfer.¹² Most lenders will not owe actual gift tax thanks to the lifetime exemption, but the return still has to be filed.

The same logic applies if you choose to forgive the debt rather than wait for it to become worthless. Forgiveness is treated as a gift of the canceled amount.¹² Because you let the borrower off the hook rather than being unable to collect, there is no bad debt to deduct, and gift tax reporting may follow if the amount clears the annual exclusion.

1
Internal Revenue Service. Topic No. 453, Bad Debt Deduction
2
Office of the Law Revision Counsel. 26 USC 166 – Bad Debts
3
eCFR. 26 CFR 1.1274-4 – Test Rate
4
Internal Revenue Service. Applicable Federal Rates (AFRs) Rulings
5
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
6
eCFR. 26 CFR 1.166-2 – Evidence of Worthlessness
7
Office of the Law Revision Counsel. 26 USC 6511 – Limitations on Credit or Refund
8
Office of the Law Revision Counsel. 26 USC 1211 – Limitation on Capital Losses
9
Office of the Law Revision Counsel. 26 USC 1212 – Capital Loss Carrybacks and Carryovers
10
Internal Revenue Service. Instructions for Form 8949
11
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
12
Internal Revenue Service. Instructions for Form 709