Determining a loan from gift important

In the second column of season, James K. Wilhelm answers questions on implications when co-signing a loan, business deductions and mutual funds

March 14, 2005

Every Monday through April 18, local tax experts will answer selected questions this tax-filing season.

To be included in the following weeks, please use the form at the right side of this page to submit your questions.

James, Baltimore: I co-signed for my son's purchase of a used truck. He stopped paying the bill, so I made all the payments last year and this year. Can that be written off as a bad debt?

Wilhelm: In order for you to deduct the truck payments, you must show that they are actually bad debts. If you lend money to a friend or a relative with the understanding that it may not be repaid, the IRS will consider the transaction a gift and not a loan. Therefore, the IRS will not allow a bad debt deduction for the amounts that were paid.

The tax treatment for a loan guarantee or co-signature situation is very similar to that of a gift. If you guarantee a debt that becomes worthless, you are not able to take a bad debt deduction for your payments on the debt, unless you can show that the reason for making the guarantee was to protect your investment or that you entered into the guarantee transaction with a profit motive.

If you make the guarantee as a favor to a friend or relative and do not receive any consideration in return, your payments are considered a gift and no deduction is permitted. Since your reason for co-signing the loan was to help your son in obtaining financing for a truck, you would not be allowed a deduction for the payments that you have made.

Unfortunately, you must also determine whether or not these payments and other gifts to your son exceeded $11,000 in 2004. If they are above this limit, then you will be required to file a gift tax return.

Steve, Crofton: I recently took a real estate course [and] also took the state test, and passed both and paid the associated fees to obtain my license. I [have no] income from the license. How do I deduct the fees?

Wilhelm: In order to deduct expenses related to your real estate activities, you must first determine if your endeavor in this industry is going to be conducted for business reasons or as a hobby. If you are in the real estate business with the intent of generating profits, then your activity would qualify as a trade or business.

If your activity qualifies as a trade or business, then you would be able to deduct ordinary and necessary expenses. Ordinary expenses are defined as expenses that are common and accepted in your industry. Necessary expenses are defined as expenses that are helpful and appropriate to your industry.

A strict interpretation of the Internal Revenue tax code would likely characterize these expenses as "start-up expenses." Start-up costs are those incurred to investigate or begin a new business. Once you commence revenue-producing activities, all ordinary and necessary costs would be deductible as noted in the paragraph above.

If these start-up expenses were incurred after Oct. 22, 2004, and they totaled less than $5,000, they could all be deducted in 2004. If the expenses were incurred prior to that date, the costs should be amortized over a 60-month period, beginning when the business was ready to generate revenue; in this case, after you had received the required licensing to sell real estate.

If this activity falls under the category of a hobby, then the costs that you incurred would not be deductible.

William, Parkville: In January 2004, I sold some mutual fund shares. Subsequently, I received a monthly statement from the fund stating that my account was credited with a $40, tax-free dividend. My concern is what is the difference between exempt-interest dividends and tax-free dividends.

Also, must these dividends be included in arriving at a taxable Social Security benefit total. I've tried the IRS for a resolution, but I just don't get it. My fund company informs me to not worry about it, just report the dividends on Form 1040, Line 8b. Any advice you can give me about this matter would be most appreciated. Thank you.

Wilhelm: Exempt-interest dividends are paid by a mutual fund to its shareholders with the dividends that are being generated by tax-exempt interest earned by the fund. When these dividends are received by the shareholders, they still retain their tax-exempt character, and therefore are not included as taxable interest income.

However, this income could increase the amount of your Social Security benefits that are taxed, since it must be reported on Line 8b of Form 1040. In addition, certain tax-exempt income is subject to the alternative minimum tax (AMT). Your 1099-DIV and/or annual statement should provide information concerning this issue.

Tax-free dividends are distributions from a mutual fund that are not generated from earnings and profits. A distribution that is not from earnings and profits is a return of capital, and as such, is not currently taxable. Keep in mind that receipt of these dividends will reduce your basis in the mutual fund shares. You do not need to include the tax-free dividends in your computation of the includible amount of your Social Security benefits, nor on Line 8b of Form 1040.