How Do My Parents Collect on an Overdue Loan?

Q: My parents, both retired, loaned a friend $60,000 six years ago to start a business. They all signed a promissory note, which was never notarized, stating that the loan would be paid back within 90 days, plus interest. Well, my parents never saw a cent. This woman comes up with story after story about when she's going to return the money. Last year my mother was diagnosed with small-cell carcinoma and underwent chemotherapy and radiation. My father explained their situation in hopes that their former friend would make a greater effort to repay them, but no luck. A lawyer said all they can do is put a lien on her house; they will get paid if she sells it (minus the lawyer's 33 percent, of course). Are there any other options?

A: As your parents have so painfully discovered, lending money often leads to a loss of both the cash and the friendship. That's why I advise people to give only to friends in need. Notice I said "give," not "loan." Then you have no expectation of being repaid, which implies two things: You're offering what you can afford to let go of, and you have no reason for resentment.

At this point, your parents' best hope is to put the lien on the house. Then if she tries to refinance or sell, they have a shot at getting their money. Their lawyer should go to court right away to get a judgment in their favor.

The one alternative to consider is writing off the loss. Your parents may be able to claim the $60,000 as a nonbusiness bad-debt deduction on their federal tax return. The IRS is going to insist on documentation to prove the money was a loan, not a gift. The original promissory note will come in handy. They'll also need to show that they have tried to collect. Assuming they've got proof to back up their claim, your mother and father can file for the deduction on Schedule D of their 1040. The money owed is treated as a short-term capital loss and must first be offset by any short-term capital gains. In the event your parents don't have any such gains (or none equal to the $60,000 debt), they'll be able to claim $3,000 a year against their income and can keep claiming $3,000 every subsequent year until they write off the whole amount.

I want you to learn from your parents' mistake. When people ask for loans, stop and think about why they're coming to you (see Look Before You Lend ). They probably have been turned down by conventional lenders. If someone in the business of loaning money says no, that should be a signal for you to do the same.