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 percent, which is the Federal rate. 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:

a. A $20,000 deduction.
b. No deduction.
c. A $3,000 deduction.
d. A $21,800 deduction.
e. None of these choices are correct.

Answer 1

The most likely scenario given that Randy is a cash basis taxpayer is that he could claim a deduction for the nonpayment of the note by his son Neil, limited to $3,000 per year against ordinary income, representing a partial recovery of the $20,000 bad debt.

Step-by-step explanation:

The proper treatment for the nonpayment of the note where Neil notified his father, Randy, that he was bankrupt and would not be able to repay the $20,000 or the accrued interest of $1,800, depends on several factors, including IRS rules for bad debt deduction and Randy's basis in the loan. If Randy has a personal (non-business) bad debt, he would be able to deduct it as a short-term capital loss, subject to a maximum annual limit of $3,000 over net capital gains. However, given the information and assuming Randy is a cash basis taxpayer with salary and interest income, the most likely scenario is that he would be able to claim the $20,000 as a capital loss, limited to $3,000 per year against ordinary income, with any remaining loss carried forward to future years. The accrued interest that was never received would typically not be deductible for a cash basis taxpayer since it was not included in income. Thus, the probable answer would be a $3,000 deduction.

According to the given information, Neil defaulted on his loan from Randy due to bankruptcy and is unable to repay the $20,000 loan amount and the accrued interest of $1,800. As a cash basis taxpayer, Randy may claim a deduction for the nonpayment of the loan under the specific bad debt provision of the tax code. However, the deductible amount would be limited to the worthlessness of the loan. Since Neil is bankrupt and unable to repay, the full amount of $21,800 can be treated as a deductible loss for Randy.