Is partially repaid loan with "no deficiency" agreement "non-business bad debt"?

[BlueHeron]

I (as an individual) lent money to a relative against real property with a written mortgage and note years ago. The borrower hadn't been paying me over the years until they sold the property last year under unfavorable conditions, and I received the entire proceeds of sale, which was less than the principal. (I never received the agreed interest for this same reason.)

The Mortgage and Note contained a No-Deficiency provision, contractually restricting me against coming after the borrower for the shortfall.

Since this loan was unrelated to my line of work or business, would the remaining unpaid principal be "non-business bad debt" that can be written off as short term loss through Form 8949, Schedule D, plus Explanation of Bad Debt? The remaining principal shortfall has become totally uncollectible. Or would the fact I agreed to a no-deficiency provision mean I have some other kind of loss, or perhaps some sort of nondeductible, non-reportable loss?

If I report this as non-business bad debt, would I need to file 1099-C cancelation of debt against the borrower? Would the borrower have to declare the unpaid principal amount as income accruing from forgiven debt? Or would the No-Deficiency provision in the contract mean that they are not considered to have forgiven debt since they are contractually excused from paying the remainder?

Thanks

[Opus 17]

Yes, this is a non-business bad debt, assuming you can prove this was a legitimate loan and not something handled as a family thing (it sounds like you have a written contract.)

You don't need to issue a 1099-C unless you are in the business of lending, so we don't need to consider whether the non-deficiency affects the issuance of a 1099-C. 

[Rick19744]

A couple of follow-up comments:

• The No Deficiency provision essentially provides the distinction between a recourse and a nonrecourse debt.  Since you indicate that the no deficiency provision restricts you from looking to the borrower for any shortfall, the debt is nonrecourse.
• I agree that this is clearly a non-business bad debt.
• While you are not required to file a form 1099-C, you are certainly not precluded from filing one.
• The IRS released a Service Center Advice 1998-020 that stated even if you are not an entity described in IRC Section 6050P that is required to issued form 1099-C, you may voluntarily file such form.  You clearly have an identifiable event; sale of the property, receipt of the proceeds which is less than the debt and the no deficiency clause.
• Keep in mind that filing form 1099-C will have tax consequences to the borrower and may impair your relationship to the borrower who you indicate is a relative and possibly other relatives.

[BlueHeron]

Since I do not need to (and will therefore not)  file 1099C, I still have the question, given that there is a no deficiency provision, does the borrower need to declare the shortfall to be income?

Why would I want to voluntarily file 1099C? Is there any possible benefit of doing so? If I am audited after declaring non-business bad debt for the unpaid portion, would that trigger generation of a 1099C by the IRS or have consequences for the borrower?

[MarilynG1]

I would advise just claiming the loss on Schedule D, being sure to save documentation for amount claimed.  The IRS would not issue any 1099-C; only you as the issuer of the loan would do that, and you are not required to.

Don't expect the borrower to declare anything on their tax return.

Here's more details on How to Report a Non-Business Bad Debt.

@BlueHeron 

[Opus 17]

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@BlueHeron wrote:

Since I do not need to (and will therefore not)  file 1099C, I still have the question, given that there is a no deficiency provision, does the borrower need to declare the shortfall to be income?

Why would I want to voluntarily file 1099C? Is there any possible benefit of doing so? If I am audited after declaring non-business bad debt for the unpaid portion, would that trigger generation of a 1099C by the IRS or have consequences for the borrower?

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It's best not to worry about someone else's tax return.  A canceled debt might or might not be taxable income depending on insolvency and other factors.  That's the borrower's problem.

There is no benefit to you to filing a 1099-C other than revenge (putting the IRS on notice to look for this income or an explanation on the borrower's return). 

[BlueHeron]

>Don't expect the borrower to declare anything on their tax return.

While I don't care for the sake of my own tax return, I am still curious

1) if they are required to report the shortfall of payment as income to themselves given that they are contractually off the hook due to the no-dependency clause?

and 2) if the answer to #1 is affected by whether I choose to take my non-business bad debt writeoff?

[Opus 17]

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@BlueHeron wrote:

>Don't expect the borrower to declare anything on their tax return.

While I don't care for the sake of my own tax return, I am still curious

1) if they are required to report the shortfall of payment as income to themselves given that they are contractually off the hook due to the no-dependency clause?

and 2) if the answer to #1 is affected by whether I choose to take my non-business bad debt writeoff?

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#1.  Its not your problem, so it's not my problem to research it.

#2. No. 

This is what the IRS says about reporting a bad debt.

How to report bad debts.

Deduct nonbusiness bad debts as short-term capital losses on Form 8949.

On Form 8949, Part I, line 1, enter the name of the debtor and “bad debt statement attached” in column (a). Enter your basis in the bad debt in column (e) and enter zero in column (d). Use a separate line for each bad debt.

Make sure you report your bad debt(s) (and any other short-term transactions for which you did not receive a Form 1099-B) on Form 8949 with box C checked..

For each bad debt, attach a statement to your return that contains:

• A description of the debt, including the amount, and the date it became due;

• The name of the debtor, and any business or family relationship between you and the debtor;

• The efforts you made to collect the debt; and

• Why you decided the debt was worthless. For example, you could show that the borrower has declared bankruptcy, or that legal action to collect would probably not result in payment of any part of the debt.

That written statement gives the IRS enough information to contact the borrower if they want to.  Turbotax does not allow PDF attachments.  I assume (I have not tested it) that Turbotax will give you some blank lines to type your responses to these questions.  Or, you can file by mail (and not e-file), and attach your own written statement.  

https://www.irs.gov/publications/p550#en_US_2023_publink100010585

[Rick19744]

@BlueHeron responses to your follow-up:

• We don't have sufficient details to determine whether the borrower needs to include the income in their tax return.  
• Our tax system is a voluntary compliance system, but complicated.  Unless the borrower received some type of form, they most likely have no idea that income might need to be reported.
• No benefit in you filing the form 1099-C
• While the IRS would not issue a form 1099-C, should you be audited and the transaction reviewed in detail, the IRS could audit the borrow.