Individuals with sound credit standing are often asked to provide credit enhancements to banks or other lenders for loans made to another person.
These credit enhancements might be required for entities in which a person has invested, in trades or businesses they operate, or for friends and relatives they wish to assist. They can lead to co-borrowers, personal guarantees, collateralization agreements and/or indemnification agreements with borrowers.
“Although the particular laws differ from state to state, when a debtor defaults on a debt that some other party has guaranteed, the debtor becomes obligated to the guarantor in an amount equal to his or her guarantee,” says Walter M. McGrail, JD, CPA, a senior manager at Cendrowski Selecky PC. “This is often referred to as subrogation and has significant tax implications.”
Smart Business spoke with McGrail about guarantees and what you should consider before serving as a guarantor.
Can making good on a guarantee result in a tax deduction?
If guarantors make good on their guarantees, the tax benefit of doing so generally depends on the reason for providing the guarantees.
A guarantee of a debt incurred in a taxpayer’s trade or business results in an ordinary loss. If the guarantee was provided for an investment that is not the taxpayer’s trade or business, the loss is a short-term capital loss.
If the guarantee was strictly personal, there is no tax deduction available to the guarantor.
In order to get an ordinary or capital loss, the taxpayer must also be able to demonstrate several facts. The obligation to make good on the guarantee must have been enforceable by the lender before the original debtor defaulted on the debt.
Also, the guarantor must have received some benefit as a result of making the guarantee, such as secured financing for the guarantor’s trade or business, or a fee from the original debtor.
If an individual taxpayer meets the criteria for obtaining a deduction, he or she may claim the related deduction in the year that the taxpayer actually made payment of the underlying debt that was guaranteed. If an individual guarantor signs a new note with the lender to make payment, then the guarantor takes a deduction each year equal to the amount that he or she actually paid during the year.
In the case of someone other than an individual cash basis taxpayer, for example, if the guarantor is an accrual basis partnership, corporation or LLC, such a taxpayer would be entitled to take the deduction in the year that such person becomes primarily liable for the debt.
