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Posted by Steve B on February 3, 2008, 10:21 pm
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This is a followup on an earlier posting, with a slightly different
query.
In 2006 we contacted a financial advisor who had been a friend many
years ago. We sought his advice on investing part of the proceeds
from the sale of our residence. He offered us the opportunity to
invest in an out-of-state land development project that he was a
partner in. The development would be sold and we would be paid out in
a few months, at which time we would reinvest the money with him in
more traditional investments. We didn't feel comfortable with that
position, so he offered us instead the opportunity to lend the money
to him on a short-term unsecured promissory note (6 months).
Needless to say, the project failed and he was unable to repay the
loan. After about a year of legal wrangling a settlement was arranged
with him paying about 45 percent cash and giving back a 5-year note
for about 25 percent of the original loan. This leaves about 30
percent uncollectible (assuming the new note pays out).
It seems that under section 166 this would be considered a
non-business bad debt. The closest case law I can find on the
Internet, which deals with inter-family loans, requires the debt to be
"totally worthless" in order to be deductible.
My questions are as follows:
Since this loan was originally negotiated with a financial advisor
(who was a partner in a firm of advisors) in anticipation of
establishing a longer term investment relationship, can this be
considered a "loss on investment"?
Does the renegotiation of the original promissory note create a loss
for individual taxpayers as it might for institutions?
Thanks for any advice you can provide. Reference to regs, if any,
would help us document our case, if there is one.
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Posted by Gil Faver on February 3, 2008, 11:03 pm
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> This is a followup on an earlier posting, with a slightly different
> query.
>
> In 2006 we contacted a financial advisor who had been a friend many
> years ago. We sought his advice on investing part of the proceeds
> from the sale of our residence. He offered us the opportunity to
> invest in an out-of-state land development project that he was a
> partner in. The development would be sold and we would be paid out in
> a few months, at which time we would reinvest the money with him in
> more traditional investments. We didn't feel comfortable with that
> position, so he offered us instead the opportunity to lend the money
> to him on a short-term unsecured promissory note (6 months).
>
> Needless to say, the project failed and he was unable to repay the
> loan. After about a year of legal wrangling a settlement was arranged
> with him paying about 45 percent cash and giving back a 5-year note
> for about 25 percent of the original loan. This leaves about 30
> percent uncollectible (assuming the new note pays out).
>
> It seems that under section 166 this would be considered a
> non-business bad debt. The closest case law I can find on the
> Internet, which deals with inter-family loans, requires the debt to be
> "totally worthless" in order to be deductible.
>
> My questions are as follows:
>
> Since this loan was originally negotiated with a financial advisor
> (who was a partner in a firm of advisors) in anticipation of
> establishing a longer term investment relationship, can this be
> considered a "loss on investment"?
>
> Does the renegotiation of the original promissory note create a loss
> for individual taxpayers as it might for institutions?
>
> Thanks for any advice you can provide. Reference to regs, if any,
> would help us document our case, if there is one.
I am interested in what develops in this thread. It seems that the original
debt was redeemed for less than your basis, and thus you have a capital
loss. So, if you made the original loan for $1,000, it was redeemed for
$450 cash and $250 new note. Your capital loss would be $300.
The rule that the security must be totally worthless means, I suppose, that
if the original loan was still being paid on, even at a small pace, you
would have to wait until the possibility of further payments completely
ceased to write off any remaining basis.
Any other thoughts out there? If one finds themselves with a bad debt that
is not totally worthless, is this type of restructuring the way to go to get
some tax benefit at the present time?
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
<< nor can it used, for the purpose of avoiding penalties >>
<< that may be imposed upon the taxpayer. >>
<< >>
<< The Charter and the Guidelines for submitting posts >>
<< to this newsgroup as well as our anti-spamming policy >>
<< are at www.asktax.org. >>
<< Copyright (2007) - All rights reserved. >>
<< ------------------------------------------------------- >>
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Posted by Steve B on February 4, 2008, 4:24 pm
Please log in for more thread options Gil Faver wrote:
>
... snipped to shorten the posting...
>>My questions are as follows:
>>
>>Since this loan was originally negotiated with a financial advisor
>>(who was a partner in a firm of advisors) in anticipation of
>>establishing a longer term investment relationship, can this be
>>considered a "loss on investment"?
>>
>>Does the renegotiation of the original promissory note create a loss
>>for individual taxpayers as it might for institutions?
>>
>>Thanks for any advice you can provide. Reference to regs, if any,
>>would help us document our case, if there is one.
>
>
>
> I am interested in what develops in this thread. It seems that the original
> debt was redeemed for less than your basis, and thus you have a capital
> loss. So, if you made the original loan for $1,000, it was redeemed for
> $450 cash and $250 new note. Your capital loss would be $300.
>
==> The rule that the security must be totally worthless means, I
suppose, that
==> if the original loan was still being paid on, even at a small pace, you
==> would have to wait until the possibility of further payments completely
==> ceased to write off any remaining basis.
>
> Any other thoughts out there? If one finds themselves with a bad debt that
> is not totally worthless, is this type of restructuring the way to go to get
> some tax benefit at the present time?
>
Aye, there's the rub (see ==> just above). It would seem that, if
viewed as a "non-business bad debt" it must be totally worthless for
individuals:
From Sec. 1.166-5(a)(2) Nonbusiness debts:
"A loss on a nonbusiness debt shall be treated as sustained only if and
when the debt has become totally worthless, and no deduction shall be
allowed for a nonbusiness debt which is recoverable in part during the
taxable year."
In the case of Buchanan v US, 87 F.3d 197, judge Posner stated:
"The Internal Revenue Code allows the deduction of a nonbusiness debt
that "becomes worthless within the taxable year," 26 U.S.C. §
166(d)(1)(B). The criterion of worthlessness is interpreted strictly:
the deduction is unavailable if even a modest fraction of the debt can
be recovered. Treas. Reg. § 1.166-5(a)(2) ("wholly worthless"); Bodzy v.
Commissioner, 321 F.2d 331, 335 (5th Cir. 1963) ("last vestige of value"
must have "disappeared"); Clanton v. Commissioner, 70 Tax Ct. Mem. Dec.
(CCH) 534 (1995) ("partial worthlessness is insufficient"). The reason
for this hard line is plain. Because people rarely make nonbusiness
loans to strangers, or even to friends, the domain of the nonbusiness
debt is limited largely to the family."
To drive the point home, he further stated:
"The taxpayers wisely do not argue that so much of their nonbusiness
debt as has not been repaid and is unlikely to be repaid, which is to
say $ 2.1 million minus the $ 480,000 that, as best we can estimate,
will be their total recovery, will be deductible in the tax year in
which the hope of further recovery is finally extinguished. Such an
approach, in which the unpaid balance of a partially recovered debt is
severed from the original unpaid balance and characterized as a
separate, totally worthless debt, would defeat the requirement of
showing complete (well, nearly complete, for the reason explained
earlier) worthlessness."
Judge Posner's full opinion and case details can be found at
http://www.projectposner.org/case/1996/87f3d197
That's why I'm wondering if the nature of the transaction can be
characterized as a loss on investment rather than a bad debt. Any
references to rulings (Tax Court or other) or regulations would be
greatly appreciated.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
<< nor can it used, for the purpose of avoiding penalties >>
<< that may be imposed upon the taxpayer. >>
<< >>
<< The Charter and the Guidelines for submitting posts >>
<< to this newsgroup as well as our anti-spamming policy >>
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<< Copyright (2007) - All rights reserved. >>
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Posted by Gil Faver on February 10, 2008, 12:31 am
Please log in for more thread options > That's why I'm wondering if the nature of the transaction can be
> characterized as a loss on investment rather than a bad debt. Any
> references to rulings (Tax Court or other) or regulations would be greatly
> appreciated.
what was the nature of your original investment? was it a loan, or an
equity interest?
Also, I have to wonder: even if it was a loan, were you not "in the
business" of making this type of loan? I'd like to see more case law, as
the case you cited was not really at all like your situation.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
<< nor can it used, for the purpose of avoiding penalties >>
<< that may be imposed upon the taxpayer. >>
<< >>
<< The Charter and the Guidelines for submitting posts >>
<< to this newsgroup as well as our anti-spamming policy >>
<< are at www.asktax.org. >>
<< Copyright (2007) - All rights reserved. >>
<< ------------------------------------------------------- >>
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Posted by EB on February 10, 2008, 11:55 pm
Please log in for more thread options wrote:
>> That's why I'm wondering if the nature of the transaction can be
>> characterized as a loss on investment rather than a bad debt. Any
>> references to rulings (Tax Court or other) or regulations would be greatly
>> appreciated.
>
>what was the nature of your original investment? was it a loan, or an
>equity interest?
>
>Also, I have to wonder: even if it was a loan, were you not "in the
>business" of making this type of loan? I'd like to see more case law, as
>the case you cited was not really at all like your situation.
Thanks for the reply.
The original investment was a loan (unsecured promissory note),
definitely not an equity interest.
According to the reading we've been able to do we would *not* be
considered in the business of making this type of loan. It was a
one-time arrangement. Never done it before, and needless to say,
never will do it again.
It's true the case law cited isn't really like our situation. The
cases we were able to find pertained to either (a) inter-family loan
arrangements or (b) business related loans. We're sort-of caught in
the middle. Unfortunately the law and regulations are unequivocal
about non-business bad debts having to be "totally worthless" in cases
like this. The court cases explain the rationale as disallowing
"shady" deals between family or friends to reduce taxes.
Surprisingly, we couldn't find any cases similar to our own situation.
Strange, considering how many news stories one hears about financial
advisors messing with client accounts...
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
<< nor can it used, for the purpose of avoiding penalties >>
<< that may be imposed upon the taxpayer. >>
<< >>
<< The Charter and the Guidelines for submitting posts >>
<< to this newsgroup as well as our anti-spamming policy >>
<< are at www.asktax.org. >>
<< Copyright (2007) - All rights reserved. >>
<< ------------------------------------------------------- >>
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