Q. I guaranteed a loan my cousin took out for his business. Now I have to pay up because he is defaulting. Is this payment deductible? B.A.W., Brooklyn, N.Y.
A. It depends. When you guarantee a loan and pay it off after the principal debtor defaults, the payment is deductible as a bad business debt only if you had a valid business reason for the guarantee (e.g., to protect a business relationship).
If you guaranteed the loan for investment reasons, it may be deducted as a nonbusiness bad debt. In that case, it is claimed as a capital loss that may offset capital gains plus up to $3,000 of ordinary income.
Tip: Conversely, if you guarantee a loan to a relative or friend merely as a favor, the IRS presumes it is a gift. Therefore, you get no deduction for your payment.