My good friend Jack is single. It's probably because his grandfather always told him, "Jack, don't marry for the money. It's cheaper to borrow." And borrow he has – from me, mostly. I know I'll never collect from him. Oh, I'll get some tax relief, for sure. Will you?
There are a few provisions in our tax law that can apply when you lend money to someone else and the loan becomes uncollectible. To start, most loans will be considered as "capital debts" (as opposed to "income debts" where, for example, you sell business inventory and take back debt owing to you for all or part of the sale proceeds). The rules I'm talking about here apply to capital debts.
As a general rule, you'll be able to claim a capital loss on a loan if the amount is truly owing to you, and you've determined the loan to be uncollectible. You need to elect in your tax return to claim the capital loss for the year the loan turns bad (visit a tax pro for help making this election). If you happen to collect any part of that debt later, the amount collected will be taxed as a capital gain at that time.
If your loan was to a small business corporation and the loan turns sour, the loan may be considered a "business investment loss," with even more relief available. One half of this loan would be the "allowable business investment loss" (ABIL), and can be applied against any type of income, not just capital gains.
There are special rules that apply to the sale of property that you own for your personal use and enjoyment (personal-use property – PUP). If you sell PUP and take back debt owing to you as part of the proceeds, you can claim a capital loss if the debt becomes uncollectible, but only to the extent you reported a capital gain on the sale of the PUP.
There's a catch here with all of these loans: Your loss from the uncollectible loan will be deemed zero unless you've charged fair market interest on the loan (or have otherwise made the loan for the purpose of earning income from a business or property). There are two exceptions: First, if the loan exists because you sold something to an arm's-length person and took back the debt as full or partial payment, then you can claim the loss even if you hadn't charged interest. Second, if the loan is to a Canadian corporation in which you own shares, and the loan was made to allow the company to earn income from a business or property, then the taxman won't require the loan to be at fair market interest.
Want some real-life examples where these rules apply? Read on.
Jackson recently sold his very expensive boat, for which he had paid $100,000, to his brother-in-law for $60,000. Jackson was paid $40,000 in cash and agreed to collect the $20,000 balance over time, without interest. As it turns out, the $20,000 balance has become uncollectible. Jackson would like to claim a capital loss for the $20,000, but he can't.
Normally, the loss on an uncollectible debt related to the sale of PUP (i.e., the boat) can be claimed to the extent the PUP itself had been sold at a profit, so the loss can offset the capital gain realized. But Jackson sold his boat for a loss. Even if he had sold it for a profit, he'd still be unable to claim the capital loss in this case because he didn't charge fair market interest on the loan (which would not have been required if he had sold the boat to an arm's-length person; but he didn't do that either).
Now, consider Susan. She lent $100,000 to a friend to help start a business. Susan made the loan directly to her friend and didn't charge any interest. The business is bankrupt and her friend is not able to pay back the loan. Unfortunately, Susan is not able to claim any losses for this loan. If she had charged fair market interest on the loan, then she would have been entitled to a capital loss in this case. Further, if Susan had made the loan to her friend's corporation (which was a small-business corporation) she'd be entitled to claim an ABIL, which can be applied against any source of income.
See my article from June 21, 2015, for more details on loans to small business corporations.
Tim Cestnick is managing director of Advanced Wealth Planning, Scotiabank Global Wealth Management, and founder of WaterStreet Family Offices.