How to Write Off Bad Debt on Your Taxes

When a debt owed to you becomes uncollectible, it may qualify as a “bad debt” for tax purposes, allowing you to deduct the loss. This deduction helps to accurately reflect your financial reality and reduce your taxable income. Understanding the specific rules for claiming a bad debt deduction can help individuals and businesses manage their financial obligations. The Internal Revenue Service (IRS) provides guidelines for determining what constitutes a bad debt and how it can be written off.

Defining Bad Debt for Tax Purposes

For a debt to be considered “bad debt” by the IRS, it must be a bona fide debt arising from a valid and enforceable obligation to pay a fixed or determinable sum of money. This means the relationship between the debtor and creditor must have been established with a genuine expectation of repayment at the time the debt was created. Loans to family or friends are scrutinized to ensure they are not disguised gifts, requiring clear documentation of intent to repay.

Bad debts are categorized into two types: business bad debt and non-business bad debt. A business bad debt is one created or acquired in a trade or business, or closely related to it when it becomes worthless. This includes uncollectible accounts receivable from credit sales or loans made to suppliers, clients, or employees. Business bad debts are deducted as ordinary losses, meaning they can offset any type of income without limitation.

Non-business bad debts encompass all other debts, such as personal loans to friends or family members, or debts arising from investment activities. Unlike business bad debts, non-business bad debts must be entirely worthless to be deductible; partial worthlessness does not qualify for a deduction. These are treated as short-term capital losses, subject to limitations on how much can be deducted against other income in a given year.

For a bad debt deduction, the amount must have been previously included in income, especially for accrual-basis taxpayers. Accrual-basis taxpayers report income when earned, even if not received, allowing them to deduct uncollectible receivables. Cash-basis taxpayers generally do not include income until received, so they typically cannot claim a bad debt deduction for unpaid services or sales because the income was never reported. An exception for cash-basis taxpayers is a loan evidenced by a note, which can be charged off if it becomes worthless.

Determining Worthlessness

Establishing that a debt is truly worthless is a crucial step for claiming a bad debt deduction. The IRS requires proof that there is no reasonable expectation the debt will be repaid. This is not based on the taxpayer’s subjective opinion alone, but on objective facts and circumstances. The debt must be deemed worthless in the tax year the deduction is claimed, not a prior or subsequent year.

Evidence of worthlessness involves demonstrating that reasonable steps to collect the debt have been exhausted without success. This may include sending demand letters, making phone calls, or engaging collection agencies. While going to court is not always necessary, proof of uncollectibility is sufficient if legal action would likely not result in collection.

Specific events can indicate worthlessness. For instance, the debtor’s bankruptcy is often sufficient evidence. Other indicators include the debtor’s insolvency, a clear refusal to pay, or the death of the debtor without sufficient assets to cover the debt. Abandonment of the debt, where the creditor gives up all attempts to collect, also signifies worthlessness.

Substantiating Your Claim

To claim a bad debt deduction, taxpayers must maintain thorough documentation to support the debt’s existence and worthlessness. This evidence is vital for proving the claim to the IRS. Establishing the debt’s legitimacy through formal documents is the initial step. This includes promissory notes, invoices, or signed contracts outlining the debt’s terms.

Records of any payments made or received on the debt must be kept, providing a clear history of the transaction and outstanding balance. Communication with the debtor is also important evidence. Copies of demand letters, emails, or detailed logs of phone calls regarding repayment attempts demonstrate collection efforts.

Documentation of collection attempts is crucial for proving worthlessness. This includes statements from collection agencies, records of legal actions, or court documents showing judgments or uncollectibility. Evidence of the debtor’s financial state, such as bankruptcy filings, financial statements, or other official proof of insolvency, further supports the claim of worthlessness. Any formal agreement to abandon the debt must also be retained.

Reporting the Deduction

The process for reporting a bad debt deduction depends on whether it is a business or non-business bad debt. Business bad debts are treated as ordinary losses and deducted directly on appropriate business tax forms. Sole proprietors report business bad debts on Schedule C (Form 1040), Profit or Loss From Business, on line 27a for “Other expenses.” Farmers report these deductions on Schedule F (Form 1040), Profit or Loss From Farming, on line 32.

For partnerships and multi-member LLCs, business bad debts are reported on Form 1065, U.S. Return of Partnership Income, on line 12. S corporations report them on Form 1120-S, U.S. Income Tax Return for an S Corporation, on line 10. C corporations deduct business bad debts on Form 1120, U.S. Corporation Income Tax Return, on line 15. These deductions reduce the business’s taxable income and can contribute to a net operating loss.

Non-business bad debts are treated as short-term capital losses. These losses are reported on Schedule D (Form 1040), Capital Gains and Losses, and Form 8949, Sales and Other Dispositions of Capital Assets. On Form 8949, Part 1, line 1, taxpayers enter the debtor’s name and indicate “bad debt statement attached” in column (a). The bad debt’s basis is entered in column (e), with zero in column (d).

Non-business bad debt deductions are subject to capital loss limitations. These losses can first offset any short-term capital gains, then long-term capital gains. If capital losses exceed capital gains, up to $3,000 ($1,500 for married individuals filing separately) of the remaining loss can be deducted against other ordinary income in a single tax year. Any unused loss can be carried over to future tax years until fully utilized. A detailed statement must be attached to the tax return for non-business bad debts, providing the following information:

• Description of the debt
• Amount of the debt
• Date the debt became due
• Debtor’s name
• Any relationship to the debtor
• Collection efforts made
• Reason the debt became worthless