Thanks. So essentially the accumulated interest that was due cannot be written off because there was no basis in that? There's no benefit at all for the seven years or so that it took to get to the discharge and make the debt worthless?
Here's another question: does the interest due and late fees, etc. that were successfully collected (before the non-payment to discharge period) reduce the initial basis or only the principal repayments do? This was an amortized loan.
Yes, this goes on Schedule D as a short-term loss subject to the $3K limitation (from Form 8949).
Oh sorry, I failed to comprehend that this was a nonbusiness bad debt even though that fact is clearly stated in the title.
Like my instructor has said, attention to detail is the most important thing in Accounting.
Anyways, unfortunately, yes the accumulated interest that was due cannot be written off because there was no basis in that. And, after maneuvering the clunky IRS website, I've even found the proof! You can read it right here:
https://www.irs.gov/publications/p550/ch04.html#en_US_2016_publink100010565
The part that you will want to read is the "Basis in Bad Debt Requirement" section, and I quote:
Internal Revenue Service said:
If you are a cash method taxpayer (most individuals are), you generally cannot take a bad debt deduction for unpaid salaries, wages, rents, fees, interest, dividends, and similar items.
So in other words, those fees and interest accumulations that you were talking about can't be included in the loss amount.
If it were specifically, a
business loan, then of course all those things can be deducted. But unfortunately, nonbusiness loans don't get that benefit.
As far as your second question goes, that's a tough one. In my accounting textbook, three main areas are covered as far as dealing with notes goes: giving out and collecting notes as part of normal operations, extending the credit period, and writing off bad debts using both the "Direct Write Off" method and the "Allowance" method. There isn't any specific information on how to handle a situation where a borrower accumulates a ton of interest, then finally makes a payment.
The book describes note payments and payments of interest as two separate things. For example, a $500 note with 12% interest for 60 days is paid in the amount of $510 where $500 is for the principle and $10 is for the interest. In fact, this is even accounted for separately being labeled as "Note Payable" to cover the principle and "Interest Expense" to cover the interest. That was in the chapter 11 "Current Liabilities". The only type of note payable listed in the chapter 14 "Long-Term Liabilities" are installment notes. Installment notes use perfectly equal payments over a period of time. At the beginning of the payback period, much of the installment payment is actually interest. As the note gets paid off, the amount of the payment that is actually interest decreases. This is known as "Decreasing Accrued Interest". For example, a 6 year installment note that required equal payments went down as follows:
Info: $60,000 at 8% for six years (equal payments of $12,979)
Year 1: 60,000 (principle) | [4800 (interest) + 8179 (principle payment = 12979-4800)] = 12979
Year 2: 51,821 (principle) | [4146 (interest) + 8833 (principle payment)] = 12979
Year 3: 42988 | [3439 + 9540] = 12979
Year 4: 33448 | [2676 + 10303] = 12979
Year 5: 23145 | [1852 + 11127] = 12979
Year 6: 12018 | [961 + 12018] = 12979
Notice how interest makes up a large chunk of the payment at the beginning of the installment payback period and decreases until interest barely makes up any part of the payment at all. The problem is that your note doesn't seem like it was an installment note, correct? Or was your note an installment note? Then maybe I answered your question? One other hint that I got from the Long-Term Liabilities section is in the case of a bond. The only thing that is actually paid is the interest until the bond matures. Only after the bond matures then is the principle paid. So again, it seems like interest is given preferential treatment in regards to being paid first. So with that being said, my educated
guess (key word being "guess") is that any payments that you were able to collect reduces the
interest first, then whatever is left over reduces the actual principle.
Finally, as I mentioned in my first paragraph, I realize now that your bad debt does indeed go on a schedule D.
Anyways, sorry that I couldn't be of more help to you in answering your second paragraph question. Unfortunately, book learning just can't cover everything that actual life experiences can.