Reporting Hard Money Loan Default as a Loss

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Reporting Hard Money Loan Default as a Loss

Bryan Price
New to Real Estate · Orange County, CA · Member since 2018 · 18 posts · 2 votes

Hi All,

I made the mistake of loaning a total of $550k about 3 years ago and have not been repaid, and am looking at my options for my personal tax return to report the loss as now I would consider the loan to be in default. I have signed paperwork documenting the original loan amounts, properties, etc. for 3 hard money loans and am waiting a state authority judgment regarding potential fraud. I believe if the loan had been repaid, the income would have been reported on a K1 form as interest. I will not be receiving any type of documents from who I loaned the money to, as that person is pretty much in hiding and dodging many creditors at the moment. 

As my original investment is a total loss, would I be able to deduct this on Schedule C to offset any W2 income? I worry that reporting a $550k loss - when I normally report about $750k in W2 income from my day job - will be a major red flag to the IRS.  However, it would be much more valuable to me if this loss were to offset ordinary income. I would feel a lot less pain if I could save ~$200k in taxes I would have already had to pay as part of my W2 income.

I know the answer is to consult a tax attorney and I plan on doing so, but I want to be armed with the most information possible.

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Jeff S.
Lender · Los Angeles, CA · Member since 2009 · 1k+ posts · 2k+ votes
8mo

You still have some options, @Bryan Price, especially if the first-position lender has not yet foreclosed. Though it appears you did not speak to a lending lawyer before you made the loan, for $550k you should speak to one now.

Fortra Law and Doss Law, both in Irvine and both lending law firms, will be able to give you some options. You might call one before you give up on this loan. Obviously, you also need a CPA, but be warned that unless you have some large lending or other investment gains to offset this potential loss, you will not like what you hear regarding offsetting against W2 income.

You might have been taken advantage of, Bryan, but don’t assume fraud. I don’t know what state authority you’re talking about or where you made these loans, but deeds of trust and mortgages are public records that you could have easily found in advance on your own. Of course, they would have been noted on the preliminary title insurance reports you received when you made these loans. You did get title insurance and required the title company to record these loans in first position, right? And personal guarantees?

I hate to hear when someone takes advantage of a lender, especially a new lender. I apologize for my cynicism, Bryan. You still have some options, but after 3 years, time is not on your side. Don’t wait.

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  • Doug Smith
    Lender · Tampa, FL · Member since 2013 · 2k+ posts · 2k+ votes
    8mo

    Hi Bryan, You're 100%, ask your tax advisor...not the peanut gallery here. I run a lending company, have an undergrad in accounting and went through the CPA track back in the day before becoming a banking exec for over 3 decades, we make loans and provide smaller, more inexperienced private lenders with contract underwriting help...so I'm way more qualified to answer that question than most...and I still go to my CPA to ask specific tax questions. BP is great for general ideas, but when you need real professional advice...to to a pro. 

    1Reply
  • Aaron ZimmermanBusiness Member
    Accountant · Chicago, IL · Member since 2018 · 2k+ posts · 1k+ votes
    8mo
    How was the money lent out? Personal name, LLC, retirement account?
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    • Bryan Price
      OP
      New to Real Estate · Orange County, CA · Member since 2018 · 18 posts · 2 votes
      8mo
      Quote from @Aaron Zimmerman:
      How was the money lent out? Personal name, LLC, retirement account?

      I lent the money out of my personal checking account. It was to an LLC with a signed promissory note by me and the LLC owner.

      0Reply
    • Aaron ZimmermanBusiness Member
      Accountant · Chicago, IL · Member since 2018 · 2k+ posts · 1k+ votes
      8mo

      @Bryan Price I would take a look at this link from the irs. It looks like this would be short term capital loss

      https://www.irs.gov/taxtopics/tc453

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  • Chris SeveneyBusiness Member
    Moderator
    Investor · VA · Member since 2015 · 21k+ posts · 19k+ votes
    8mo
    Quote from @Bryan Price:

    Hi All,

    I made the mistake of loaning a total of $550k about 3 years ago and have not been repaid, and am looking at my options for my personal tax return to report the loss as now I would consider the loan to be in default. I have signed paperwork documenting the original loan amounts, properties, etc. for 3 hard money loans and am waiting a state authority judgment regarding potential fraud. I believe if the loan had been repaid, the income would have been reported on a K1 form as interest. I will not be receiving any type of documents from who I loaned the money to, as that person is pretty much in hiding and dodging many creditors at the moment. 

    As my original investment is a total loss, would I be able to deduct this on Schedule C to offset any W2 income? I worry that reporting a $550k loss - when I normally report about $750k in W2 income from my day job - will be a major red flag to the IRS.  However, it would be much more valuable to me if this loss were to offset ordinary income. I would feel a lot less pain if I could save ~$200k in taxes I would have already had to pay as part of my W2 income.

    I know the answer is to consult a tax attorney and I plan on doing so, but I want to be armed with the most information possible.


     Were you in 1st position? If so, why not foreclose on the properties? Did you also get a personal guarantee that you could go after? 

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    • Bryan Price
      OP
      New to Real Estate · Orange County, CA · Member since 2018 · 18 posts · 2 votes
      8mo
      Quote from @Chris Seveney:
      Quote from @Bryan Price:

      Hi All,

      I made the mistake of loaning a total of $550k about 3 years ago and have not been repaid, and am looking at my options for my personal tax return to report the loss as now I would consider the loan to be in default. I have signed paperwork documenting the original loan amounts, properties, etc. for 3 hard money loans and am waiting a state authority judgment regarding potential fraud. I believe if the loan had been repaid, the income would have been reported on a K1 form as interest. I will not be receiving any type of documents from who I loaned the money to, as that person is pretty much in hiding and dodging many creditors at the moment. 

      As my original investment is a total loss, would I be able to deduct this on Schedule C to offset any W2 income? I worry that reporting a $550k loss - when I normally report about $750k in W2 income from my day job - will be a major red flag to the IRS.  However, it would be much more valuable to me if this loss were to offset ordinary income. I would feel a lot less pain if I could save ~$200k in taxes I would have already had to pay as part of my W2 income.

      I know the answer is to consult a tax attorney and I plan on doing so, but I want to be armed with the most information possible.


       Were you in 1st position? If so, why not foreclose on the properties? Did you also get a personal guarantee that you could go after? 


       I was the 2nd position on a property that would not pay off the loan. It was very bad due diligence on my part, and likely fraud since the 1st lien was not disclosed.

      0Reply
  • Jeff S.
    Lender · Los Angeles, CA · Member since 2009 · 1k+ posts · 2k+ votes
    8mo

    You still have some options, @Bryan Price, especially if the first-position lender has not yet foreclosed. Though it appears you did not speak to a lending lawyer before you made the loan, for $550k you should speak to one now.

    Fortra Law and Doss Law, both in Irvine and both lending law firms, will be able to give you some options. You might call one before you give up on this loan. Obviously, you also need a CPA, but be warned that unless you have some large lending or other investment gains to offset this potential loss, you will not like what you hear regarding offsetting against W2 income.

    You might have been taken advantage of, Bryan, but don’t assume fraud. I don’t know what state authority you’re talking about or where you made these loans, but deeds of trust and mortgages are public records that you could have easily found in advance on your own. Of course, they would have been noted on the preliminary title insurance reports you received when you made these loans. You did get title insurance and required the title company to record these loans in first position, right? And personal guarantees?

    I hate to hear when someone takes advantage of a lender, especially a new lender. I apologize for my cynicism, Bryan. You still have some options, but after 3 years, time is not on your side. Don’t wait.

    2Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    8mo

    @Bryan Price, tough situation. I’ve seen this before and I get why you’re trying to soften the blow from a tax angle.

  • From a pure tax standpoint, this almost never goes on Schedule C. Unless you are in the business of lending money, the IRS treats this as a nonbusiness bad debt, which means capital loss treatment. That limits how much can offset W-2 income each year, with the rest carried forward. It’s frustrating, but that’s the default rule.

    Where this can change is fraud. If a court or state authority ultimately establishes fraud or theft, the loss may qualify as a theft loss, which can potentially be treated as an ordinary loss. Timing and documentation are everything there, and that determination usually drives when and how it’s deducted.

    On audit risk, the dollar amount alone is not the problem. Misclassifying it is. Forcing a $550k loss onto Schedule C without strong facts is what gets attention.

    I also agree with what Doug said. BP is great for framing the issue and knowing what questions to ask, but this is absolutely a tax attorney and CPA conversation, not something to crowdsource a final answer on.

    Good luck to you, and happy to connect.

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