When filing your taxes each year, the IRS allows you a deduction for bad debt. Now, this doesn't mean your bad debt; it means debt owed to you. Perhaps you made a loan to a colleague to help her start her small business, but then she had to file for bankruptcy. Or lent some cash to a friend who needed it to pay his rent, but this so-called "friend" disappeared and you never heard from him again.
That's bad debt, because you'll never get that money back. Bad debt is a debt that is uncollectable. Unfortunately, the money is gone forever. Fortunately, Uncle Sam will help you out by letting you deduct that lost money on your taxes. But, as with everything regarding taxes, the government needs you to meet certain requirements before you can take this deduction.
On the next few pages, we'll explain the ins and outs of bad debt, and how to properly deduct it from your taxes.
What Qualifies as Bad Debt?
There are two types of bad debts -- business and non-business. This article focuses on non-business bad debt. Non-business debts include making loans for personal investments or personal activities. For example, lending money to family, friends, or other people for any non-business purpose is a non-business debt. Your loan cannot in any way be connected to your business or trade.
To deduct bad debt from your taxes, the debt needs to meet certain qualifications in the eyes of the IRS. You must show that:
- The debt is real
- You have already lent out the money
- The debt is worthless; there is no way of getting any of the money back
- You have taken reasonable steps to collect the debt
There are other stipulations about the debt as well. It must be a loan, not a gift. When you give someone money (for example, help your son or daughter buy a car) with the understanding it won't be repaid, you cannot deduct that money from your taxes. There must be a debtor-creditor relationship, with both parties understanding the money will be repaid. When you lend someone money, even to a trusted friend, put it in writing (such as a promissory note) with repayment terms and interest. The IRS tends to look at non-interest loans as gifts.
You can't claim bad debt on money you were already expecting -- you must have lent out cash. This means you can't claim bad debt on things like unpaid child support, unpaid wages, or rent.
The entire loan must be uncollectible. For example, say you lend your cousin $1,000 and he pays you back $100, but then says he can't pay back any more. You can't claim the remaining $900 as a bad debt on your taxes, because he did make a partial effort to pay you back.
You must file for the deduction in the year the debt became worthless. You may be able to amend a back tax return to deduct for a bad debt. Typically you have seven years to amend your return to claim for a bad debt, but check with your tax professional on how to do this.
If the debt meets all of these requirements, read on to learn how to claim the bad debt tax deduction.
Deducting Bad Debt From Your Taxes
Now that you know what bad debt is, here's the skinny on how to deduct it from your taxes.
- In Part 1, you'll enter the name of the debtor and "bad debt statement attached" in Column A
- Enter "0" in Column D
- Enter the basis of your debt in Column E
- Make sure you use a separate line for each bad debt if you have more than one
The IRS requires a separate attachment, listing the following:
- A description of the debt, the amount, and the date it was due to you
- The debtor's name and his/her relationship to you (remember, the IRS almost always considers loans to friends and families to be gifts, unless you have paperwork showing otherwise)
- The ways in which you attempted to collect on the debt
- Why and how you determined the debt was worthless
What if you deduct bad debt on your tax return, but then later your debtor shows up and pays you back? Next time you file, you'll have to include that recovery as part of your income. The amount you report, however, is limited just to the amount you deducted. Report this recovery as "other income" on your tax form.
Of course, if you have any questions on how you should handle bad debt on your tax return, check with a trusted tax professional to ensure you follow the correct procedure.
- Fishman, Stephen, J.D. "When Can You Deduct Nonbusiness Debts?" Nolo.com. 2014. (Oct. 13, 2014) http://www.nolo.com/legal-encyclopedia/when-can-you-deduct-nonbusiness-debts.html
- IRS. "Nonbusiness Bad Debts." 2014. (Oct. 13, 2014) http://www.irs.gov/publications/p550/ch04.html#en_US_2013_publink100010565
- IRS. "Recovery of a Bad Debt." 2014. (Oct. 13, 2014) http://www.irs.gov/publications/p535/ch10.html#en_US_2013_publink1000154215
- Lawyers.com. "Deduction for Nonbusiness Bad Debts." Internet Brands. 2014. (Oct. 13, 2014) http://taxation.lawyers.com/income-tax/deduction-for-non-business-bad-debts.html
- Phillips Erb, Kelly. "Taxes From A To Z (2013): B Is For Bad Debt Expense." Forbes. March 5, 2013. (Oct. 13, 2014) http://www.forbes.com/sites/kellyphillipserb/2013/03/05/taxes-from-a-to-z-b-is-for-bad-debt-expense/