IRS Rules Regarding Bad Debt Deduction
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If someone owes you money that you cannot collect, you may have a bad debt. For a discussion of what constitutes a valid debt, refer to Publication 550, Investment Income and Expenses, and Publication 535, Business Expense.
To deduct a bad debt, you must have previously included the amount in your income or loaned out your cash. If you are a cash basis taxpayer, you may not take a bad debt deduction for money you expected to receive but did not (for example, for money owed to you for services performed, or rent) because that amount was never included in your income. For a bad debt, you must show that there was an intention at the time of the transaction to make a loan and not a gift. If you lend money to a relative or friend with the understanding that it may not be repaid, it is considered a gift and not a loan.
There are two kinds of bad debts – business and non business.
Generally, a business bad debt is one that comes from operating your trade or business.
The following are examples of business bad debts (if previously included in income):
Loans to clients and suppliers
Credit sales to customers, or
Business loan guarantees
A business deducts its bad debts from gross income when figuring its taxable income. Business bad debts may be deducted in part or in full. You can claim a business bad debt using either the specific charge-off method or the non accrual-experience method.
All other bad debts are non-business. Non-business bad debts must be totally worthless to be deductible. You cannot deduct a partially worthless non-business bad debt.
A debt becomes worthless when the surrounding facts and circumstances indicate there is no reasonable expectation of payment. To show that a debt is worthless, you must establish that you have taken reasonable steps to collect the debt. It is not necessary to go to court if you can show that a judgment from the court would be uncollected. You may take the deduction only in the year the debt becomes worthless. You do not have to wait until a debt is due to determine whether it is worthless.
A non business bad debt is reported as a short–term capital loss in Part 1 on Form 1040, Schedule D (PDF). It is subject to the capital loss limitations. A non business bad debt deduction requires a separate detailed statement attached to your return.
