Deducting Bad Debts
Generally, 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, money owed to you for services performed or rent. This is because, the 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:
A business bad debt is one that comes from operating your trade or business and is deducted on your business income tax return.
The following are examples of business bad debts (if previously included in income):
- Loans to clients and suppliers
- Credit sales to customers
- 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 nonaccrual-experience method.
All other bad debts are nonbusiness. Nonbusiness bad debts must be totally worthless to be deductible. You cannot deduct a partially worthless nonbusiness 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 uncollectible. 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 nonbusiness bad debt is reported as a short-term capital loss on Form 8949 (PDF), Sales and Other Dispositions of Capital Assets, Part 1, line 1.
- Enter the name of the debtor and "bad debt statement attached" in column (a).
- Enter your basis in the bad debt in column (e) and enter zero in column (d).
- Use a separate line for each bad debt. It is subject to the capital loss limitation.
- A nonbusiness bad debt deduction requires a separate detailed statement attached to your return.