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A: You can write off the unpaid balance of the loan as a bad debt. Unless you are in the business of making loans, however, the debt is treated as a non–business bad debt. This means you can claim it as a short–term capital loss, provided it is wholly worthless. Such short–term capital loss can fully offset any capital gains you may have, but any loss in excess of capital gains for the year can offset ordinary income only up to $3,000 (excess amounts can be carried forward and used in subsequent years). (You can't deduct the interest you would have earned on the loan because you never reported it into income.)

For more information about bad debts, see IRS Publication 535, Business Expenses.