How Do I Write Off Bad Debt On My Tax Return?

Written by: Patricia Tokar, CPA • Edited by: Donna Cosmato
Updated Jan 5, 2011

If someone owes you money, either from a loan or other transaction, and fails to pay you, then you likely have a bad debt. If you make efforts to collect the debt and are still not paid, then usually the bad debt can be written off on your tax return.

Is the Debt Eligible for Write Off?

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A deductible bad debt must be a result of either actual money loaned or of a loss on previously reported income. You cannot write off a loss of income that you should have received if it has not already been included in your income, such as uncollected child support or uncollected rent for a cash-basis taxpayer, or even loss of profits on a deal that did not materialize. If you are on the accrual basis and have already included an invoice in your taxable income, then if the customer fails to pay that invoice, you may claim a bad debt. Otherwise, the total uncollected invoice would not be deductible as a bad debt since it had not yet been included in your income.

Is This a Business or Personal Bad Debt?

To determine how to write off a bad debt on your tax return, you must determine whether the debt is a business bad debt or a personal bad debt. Business bad debt is a debt created as part of the ordinary course of business or as something that was closely related to the business. For example, it is a business bad debt if a customer fails to pay their invoice if you are on the accrual basis of accounting. An example of a bad debt closely related to the business would be if the business, or one of the owners of the business, loaned a sum of money to a supplier who later failed to repay the loan.

How to Write off a Business Bad Debt on the Tax Return

Business bad debts are considered a business expense and are deducted on the business tax return in the year it becomes worthless. For example, a corporate bad debt would be deducted on a line item on the front of the Form 1120. If the business bad debt is for a sole proprietorship, it would be deducted on the Schedule C. Business bad debts are deductible in full. The bad debt may create a net operating loss, which could be carried backward or forward, depending on how you elect to treat it.

How to Write off a Personal Bad Debt on the Tax Return

If the debt had no connection to business activity or purpose, then it would be considered a personal bad debt. Usually this is a result of making a loan to a friend or relative who fails to repay the loan. This type of bad debt is considered a short-term capital loss and is claimed on Schedule D of the Form 1040. As such, it will first be matched with the capital gains on the Schedule D. Any remaining loss after matching against capital gains will then flow from the Schedule D to the front of the Form 1040, with a limit of $3000.00 per year ($1500.00 for married filing separately) in deductible capital losses. The balance will be carried forward to future years and reported as a carry forward on the next year's Schedule D.

Personal bad debts must be carefully documented and this is especially important if the bad debt was to a relative. Under audit, the IRS will request a copy of the promissory note or other proof that the loan was really a loan and not intended to be a gift.

For both personal and business bad debts, but again especially for personal bad debts (and add emphasis to that if the loan is to a relative), it is crucial to have careful documentation on your efforts to collect the debt. Normally this includes copies of demand letters and other collection correspondence. It would also include the services of an attorney or filing a collection lawsuit. If you make no effort to collect a personal bad debt, then in general you may not write it off the bad debt on your tax return.

When to Write off a Bad Debt on Your Tax Return

The debt must be written off in the year it becomes worthless. It may not be written off in later years. However, if a business debt becomes partially worthless in one year, then under most circumstances the partial amount can be written off in that year and the rest written off as it becomes worthless. In general, personal bad debt may not be partially written off. Check with your tax accountant if you have a partially worthless personal bad debt.

Sometimes, it is hard to determine when a debt becomes worthless, and it is only in a later year that you realize that the debt has become uncollectible. In this case, you would be required to file an amended return to write off the bad debt on the tax return for the year that the debt became worthless.

References

IRS Publication 550 - Investment Income and Expenses

IRS Publication 535 - Business Expenses

2010 Form 1040 Schedule D

Use Publication 550 for information on personal bad debt.

Use Publication 535 for more information on business bad debt.

Legal Section

LEGAL SECTION

This article is not intended to be specific tax advice. It is intended as a general guideline only. Any specific advice should be sought from your tax professional.

CIRCULAR 230 DISCLOSURE: Pursuant to Treasury Department guidelines, any federal tax information contained in this article, or any attachment, does not constitute a formal tax opinion. Accordingly, any federal tax advice contained in this communication, or any attachment, is not intended or written to be used, and cannot be used, by you or any other recipient for the purpose of avoiding penalties

Capital Losses and Tax Deductions

Reporting Gains and Losses on the Schedule D

Federal Income Taxes - The Form 1040

The Fair Debt Collection Act

Patricia Tokar, CPA Feb 11, 2012 4:14 AM

RE: How Do I Write Off Bad Debt On My Tax Return?

First, I'm puzzled as to why the insurance company sent the 1099 to you if they did not directly issue the check to you. The best way to handle this would be to contact the insurance company and request that they re-issue the 1099 for the correct amount. Or did the insurance company issue the check in your name and the family member cashed it and kept most of it? That sounds like theft. Regardless, the $3031.00 would not actually be a bad debt - it does not sound like you loaned the money to the family member. Further, to write it off as a bad debt, you would have to show your sincere efforts to collect the money. This would be in the form of letters demanding the money, and might even include court litigation in a effort to collect the $3031.00. If you are not able to get a corrected 1099, the check was not in your name, and this is your only self-employment income, then consider reporting only the $1500.00 on your return and attaching an explanation of the discrepancy between the 1099 and the amount reported on your Schedule C. As an alternative, if the family member did indeed do some of the work and that is why they kept the $3031, then it may be appropriate to issue them a 1099-MISC for that amount. In that case, you would report the entire 4531.00 and then take the 3031.00 as a deduction for contract labor. I'd have to know more about this to really give any definite answers. The best approach, however, would still be to get a corrected 1099. Refer to Circular 230 disclosure above.

RAGMMG Feb 5, 2012 3:44 PM

I made a loan to an LLC that has filed banruptcy. Is this considered a business bad debt or a personal bad debt

MARCOUX846 Feb 5, 2012 12:04 PM

I was working on an insurance job, remodeling their basement, for a family member. The insurance company sent the claim money (check) to the family member. I was suppose to get the full amount on completion. She cashed the check and only gave me $1500 in total for doing the job. The insurance company issued me the 1099 for the full $ 4,531 amount. Can I write off the other $3,031 as bad debt or cancellation of debt? I know I should have to pay tax on the amount received, do I have to issue her any type of form?

Patricia Tokar, CPA Mar 14, 2011 8:58 PM

Write Off - Bankruptcy

Christine, in general the year that you write off the debt is the year that the debt becomes worthless. In general, with a bankruptcy that is usually the year of the bankruptcy discharge. However, I would ask that you consult with an attorney or at least your local title company since a judgment against a piece of real property must be carefully handled by the bankruptcy attorney (often it is not) or else it will survive the bankruptcy. There is a small chance that your judgment is still valid - check that first.

Christine Mar 12, 2011 2:35 PM

I loaned $$$/was not repaid/got settlement/he claimed bankruptcy

*I loaned money 2005
*took him to court 2007 and won settlement, put a lien on his property
*he claimed bankruptcy 2008
*can I show this a a bad personal debt? for what years?
LOTS of $$$ in the 10s of thousands.

TAX EXPERT Feb 27, 2011 6:26 PM

SELLING BAD DEBT

The bad debt that they are selling would be moved to the profit side of the ledger. They (the seller) would then pay the tax rate based on the amount that they sold the debt for and it would be then treated at the highest tax rate (i,e, no expeses against it, say capital equipment) and then the collection agency would have a cost basis of what they paid for the said bad debt minus what the paid and got from the debtor, The debtor would and could file an 1040x from the year that they the cancellation of ebt form and amend there taxes.

Betty Bultman Feb 15, 2011 4:37 PM

Writing off Personal Loan on taxes

I loaned my brother-in-law some
money in 2007 and he has never repaid
me to date. I have proof of e-mails etc.,
to provide intent to pay me. How can I
write this bad debt off as I don't think he
will ever pay me now.
Thanks for your help.

Anonymous Jun 10, 2010 7:12 PM

Does writing of the Bad Business Debt as a Loss

Dont you release the debtor of responsibility for the debt by writing it off like you never recieved a transaction since it is null and void then? So why can Business then turn around and Sell the Debt to earn a little money from it and the businesss buying the debt then Collects what has been take off Your Taxes as Income. Since it was no longer Income then it is not Owed by the Lender per your agreement with them. If you are agreeing with them they buy selling it you are breaking your agreement and should be beable to write off you bad debt you TOLD the Government that is what you would do?