written by: Patricia Tokar, CPA•edited by: Donna Cosmato•updated: 1/5/2011
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.
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Is the Debt Eligible for Write Off?
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.
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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.
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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.
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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.
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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.
Use Publication 550 for information on personal bad debt.
Use Publication 535 for more information on business bad debt.
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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