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Getting stiffed on a loan? A tax break may ease the pain

Have you ever had a friend in constant financial need? My good friend Scott is like that. Ever since we were little kids, he'd borrow money from anyone who'd lend it to him.

Even Scott's dad got tired of lending him money. I remember one occasion when we were teenagers and were going on a double date. Scott needed a few bucks because he didn't want to ask his girlfriend to foot the bill yet again.

"Dad, can I borrow 25 bucks?" Scott asked.

Without missing a beat, his dad responded: "25 bucks? What do you need 20 bucks for? All I have is 10, here, have five."

Scott's girlfriend provided the rest from what I recall. I don't think she ever collected on that loan.

The question is this: When you lend money and the loan goes sour, is there tax relief available? The answer depends on the type of loan. Let me explain.

The loans

There are really two categories of loans. Business loans and personal loans. Let me talk about business loans first.

If you lend money to (or invest in the shares of) a small business corporation (SBC), and the loan turns sour, you may be able to claim some tax relief.

I'm referring to an "allowable business investment loss" (ABIL). If you're eligible to claim an ABIL, 50 per cent of the uncollectible loan can be claimed against any source of income you might have in that year.

The key here is that the company borrowing the money must be an SBC. Basically, this is a Canadian-controlled private corporation that uses all or substantially all (about 90 per cent) of its assets in an active business carried on primarily in Canada. You'll need to talk to a tax pro if you think you have an ABIL because there are other rules that can restrict the claim.

Now, for personal loans. You can forget about claiming any kind of loss for personal loans that are not made to earn income. So, Scott's girlfriend can forget about claiming a loss for that 20 bucks she lent him many years ago.

If, however, you lend money and charge a rate of interest on that loan, which should be evidenced by a promissory note, you'll be able to claim a capital loss if the loan becomes uncollectible later. Now, a capital loss is not as flexible as an ABIL because it can only be applied to reduce capital gains -- but it's better than nothing. The key is that the loan must be made to earn income.

As an aside, you won't be able to claim a loss if the reason you're owed money was that you sold personal-use property (like a car, cottage or jewellery, for example) to the debtor.

The strategies

Keep these tips in mind if you're going to be a lender.

Have the borrower set up an SBC first, then make the loan to the corporation to provide potential ABIL treatment later.

Charge some interest on personal loans to turn them into income-producing loans to provide potential capital loss treatment later. Make sure the borrower signs a promissory note.

Consider claiming an ABIL in the year a loan to an SBC turns sour. This may mean filing an adjustment to a prior year return to make the claim.

Visit a tax pro if you want to claim an ABIL or capital loss for a debt gone bad, because a special election may have to be filed under subsection 50(1) of the Income Tax Act.

Tim Cestnick, FCA, CPA, CFP, TEP, is a tax specialist and author of Winning the Tax Game 2005 and The Tax Freedom Zone.

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