What to do when you can't collect a loan

A sad but common experience is that you've made a personal loan to a friend or family member and they can't or won't pay you back.  The good news is that you may qualify for a tax deduction to help recover some of your money.  Here's a quick summary of the rules.

The loan must be worthless.  You can take a deduction for a bad loan only in the year that it becomes completely worthless (rules for business loans are different).  So you take the write-off when it becomes clear that you're not going to collect any of the money that's still unpaid.

The loss may be limited.  Uncollectible personal loans are considered short-term capital losses.  You combine your loan loss with your other investment gains and losses.  Your combined net loss is limited to $3,000 in any year, but you can carry forward unused amounts to future years.

You'll need documentation.  You must have evidence of the loan amount and the fact that it is worthless.  Ideally you should put something in writing when you make the loan, even though that can be difficult to do with family members.  Failing that, try to get a letter acknowledging the loan amount and keep a copy of any check you wrote.  You also need to show that you've made efforts to collect on the loan and that your efforts have been unsuccessful.  Keep notes of your collection attempts and the results.  Remember, the better your documentation, the better the chance that the deduction will stand up if your return is audited by the IRS.