Question

Five years ago, Randy loaned his son Neil $20,000 to start a business. A note was executed with an interest rate of 8%. The note required monthly payments of the interest with the $20,000 due at the end of 10 years. Neil always made the interest payments until last year. During the current year, Neil notified his father that he was bankrupt and would not be able to repay the $20,000 or the accrued interest of $1,800. Randy is a cash basis taxpayer whose only income is salary and interest income. The proper treatment for the nonpayment of the note is:____

Answer 1

Randy can claim a nonbusiness bad debt deduction in the form of a short-term capital loss for the unpaid $20,000 loan principal, but cannot deduct the unpaid accrued interest of $1,800 as it was not received and he is a cash basis taxpayer.

Step-by-step explanation:

When Randy's son Neil declared bankruptcy and could not repay the $20,000 loan or the accrued interest of $1,800, the treatment for nonpayment depends on Randy's circumstances as a cash basis taxpayer. Typically, Randy would be able to claim a nonbusiness bad debt deduction. This deduction is taken as a short-term capital loss on Schedule D of Randy's tax return. Randy would report the loss in the year the debt became worthless.

Randy cannot deduct the unpaid interest because as a cash basis taxpayer, he only reports income when it is actually received. Therefore, the accrued interest of $1,800 which was not received does not form part of his taxable income and cannot be deducted as it was never included in his income.

On the other hand, with the principal amount of $20,000, Randy can claim a bad debt deduction because this was money that he had previously earned and thus had been included in his taxable income.