How to Write Off a Bad Debt on Your Tax Return

When a person or business is owed money that cannot be collected, these uncollectible amounts may be deductible for tax purposes. Known as bad debts, the Internal Revenue Service (IRS) permits taxpayers to claim a deduction for these, which can reduce their taxable income. Understanding the criteria and processes helps individuals and businesses accurately claim these losses.

What Qualifies as a Bad Debt

For tax purposes, a bad debt must meet criteria to be deductible. The debt must be bona fide, meaning it arises from a true debtor-creditor relationship with an enforceable obligation to pay a fixed amount. A loan must be distinguished from a gift; if no repayment was expected, it is a gift, not a deductible bad debt. The debt must also have a basis, meaning the amount was previously included in income or cash was loaned. Cash method taxpayers, like most individuals, cannot deduct unpaid items such as salaries, wages, rents, or fees, as these were never included in taxable income.

The IRS categorizes bad debts into two main types: business bad debts and non-business bad debts, with distinct tax treatments. Business bad debts arise from the operation of a trade or business. Examples include unpaid invoices for goods or services, or loans made to vendors, clients, or employees. Related to business activity, their worthlessness results in an ordinary loss.

In contrast, non-business bad debts are not directly related to a trade or business. They often involve personal loans to friends or family, or debts from investment activities. Unlike business bad debts, non-business bad debts must be wholly worthless to be deductible. They are treated as short-term capital losses, regardless of how long the debt was outstanding. They are subject to capital loss limitations, offsetting capital gains and up to $3,000 of other ordinary income per year.

Determining When a Debt is Worthless

A debt must be wholly worthless to be deductible as a non-business bad debt, with no reasonable prospect of recovery. For business bad debts, both partially and wholly worthless debts may be deductible. Worthlessness is a factual determination, and the taxpayer must prove the debt became worthless in the tax year the deduction is claimed.

Worthlessness is not merely non-payment; it requires evidence of no reasonable expectation of repayment. This involves showing reasonable, unsuccessful collection steps. It is not necessary to pursue legal action if it can be demonstrated that a court judgment would be uncollectible.

Evidence supporting worthlessness includes: Debtor bankruptcy is a strong indicator. Other evidence includes debtor death with no collectible estate, inability to locate the debtor, or expiration of the statute of limitations after reasonable collection efforts.

Unsuccessful collection efforts (e.g., demand letters, phone calls, collection agencies) serve as proof. If secured property is sold and the debt remains uncollectible, worthlessness is indicated. Facts and circumstances must clearly indicate no realistic chance of repayment.

Substantiating Your Claim

Proper documentation and record-keeping are fundamental for a bad debt deduction. The IRS requires adequate records to substantiate the debt’s existence, basis, and worthlessness. Without sufficient evidence, the IRS may deem it a nondeductible gift.

To prove the debt was bona fide and not a gift, retain documents like promissory notes, loan agreements, or written acknowledgments of debt and repayment terms. While an oral agreement may be permissible, written documentation provides stronger proof of a genuine loan. Records showing the amount loaned or debt basis are also necessary.

Evidence of worthlessness is important. This includes records of collection efforts (e.g., demand letters, emails, phone call notes). Legal documents (e.g., lawsuit filings, court judgments, unsuccessful enforcement attempts) should be kept. If the debtor filed for bankruptcy, documentation like bankruptcy notices or insolvency declarations is important. Debtor correspondence acknowledging inability to pay or financial distress also serves as substantiation.

How to Claim the Deduction

Once a debt is wholly worthless and documentation gathered, the deduction method depends on whether it is a business or non-business bad debt. Claim the deduction in the correct tax year: the year the debt becomes wholly worthless. If worthlessness was determined in a prior year, an amended return (Form 1040-X) may be necessary.

For non-business bad debts, the deduction is reported as a short-term capital loss. Report the loss on Form 8949, Sales and Other Dispositions of Capital Assets, then transfer it to Schedule D (Form 1040), Capital Gains and Losses. Attach a separate detailed statement for each non-business bad debt, including its description, amount, due date, debtor’s name and relationship, collection efforts, and reason for worthlessness. Non-business bad debts are subject to capital loss limitations.

Business bad debts are treated as ordinary losses, deducted as an expense on the applicable business tax return. Sole proprietors and single-member LLCs report these on Schedule C (Form 1040), Profit or Loss from Business. Partnerships and multi-member LLCs report them on Form 1065, U.S. Return of Partnership Income.

Corporations, including LLCs taxed as corporations, report business bad debts on Form 1120, U.S. Corporation Income Tax Return, or Form 1120-S for S corporations. Unlike non-business bad debts, business bad debts can be deducted even if only partially worthless. The deducted amount must have been previously included in the business’s gross income.