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Can I deduct a bad debt on my tax return?
Yes. If someone or a business owes you money and you cannot collect, you have a bad debt. There are two kinds of bad debts- business and non-business.
Business bad debts are fairly straightforward and come from operating your trade or business. All other bad debts are non-business and are deductible only as short-term capital losses. Capital losses can offset capital gains without limit. And excess capital losses can be applied against non-capital gain income such as wages, but are limited to $1,500 per year for single filers and $3,000 per year for joint filers.
For example, a hair stylist made personal loans to several friends who were not clients. Some of these loans became worthless, and she could not collect. Since these loans were not connected to her business as a hair stylist, they are deductible only as non-business bad debts.
Worthless: Non-business loans must be totally worthless in order to be deducted. You cannot deduct a partially worthless debt.
Debtor-Creditor Relationship: To deduct a bad debt, a debtor-creditor relationship must exist based on a valid and enforceable obligation to repay a fixed or determinable sum of money. You must also show that the transaction was 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. You cannot take a bad debt deduction for a gift. The IRS has also determined that when minor children borrow from their parents to pay for basic needs, a debtor-creditor relationship does not exist.
Basis In Debt: To deduct a bad debt, you must have a basis in it. In other words, you must have already included the amount in your income or lent cash. For example, you cannot claim a bad debt deduction for court-ordered child support not paid to you by your former spouse. You generally cannot take a bad debt deduction for unpaid salaries, wages, rents, fees, interest, dividends, and similar items. Since these amounts were not originally included in your taxable income, by definition you already have a tax benefit. Court ordered judgments are also considered bad debts if you cannot collect.
In other words- 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, for money owed to you for services performed, or rent) because that amount was never included in your income.
When To Deduct: You can take a bad debt 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. For example, you lend money to a friend and before the due date, your friend informs you that he has filed for bankruptcy and cannot pay. Although the due date might be the following tax year, the debt is worthless now and can be deducted in the current tax year.
Loan Guarantees: If you guarantee a debt that becomes worthless, you cannot take a bad debt deduction for your payments on the debt unless you can show either that your reason for making the guarantee was to protect your investment or that you entered the guarantee transaction with a profit motive. If you make the guarantee as a favor to friends and do not receive any consideration in return, your payments are considered a gift and you cannot take a deduction.
When you make payment on a loan you guaranteed, you may have the legal right to take the place of the lender (the right of subrogation). The debt is then owed to you. If you have this right or some other right to demand payment from the borrower, you cannot take a bad debt deduction until these rights become totally worthless.
Amended Tax Return: Filing an amended tax return (Form 1040X) based on a bad debt or worthless security generally must be filed within 7 years after the due date of the return for the tax year in which the debt or security became worthless. This is one of the few exceptions to the typical 3 year rule for amended tax returns.
Here is what the IRS says about deducting bad debts.