If someone owes you money, whether a customer, client, business, or borrower fails to pay, you may be able to claim a tax deduction for the loss. But not every uncollected invoice or loan qualifies.
For example, a taxpayer might try to write off a capital contribution to a business entity that underperformed. Or a taxpayer might have advanced cash to a friend or relative with the unrealistic hope that the money would be paid back, but nothing was put in writing.
To claim a deductible bad debt loss that will survive IRS scrutiny, you must first prove that the loss was from a legitimate loan transaction gone bad — not merely some other ill-fated financial move. Then, you must make another important distinction: Is it a business or nonbusiness bad debt?
A bad debt refers to money owed to you that you cannot collect either because a borrower defaulted, went bankrupt, died, or after exhaustive collection efforts you conclude recovery is impossible.
To qualify, there must have been a genuine loan or debt obligation, not a gift at the time you rent or extended credit.
For a deduction, the debt must be shown to be “worthless” in the tax year claimed i.e., you must reasonably conclude there is no reasonable expectation of repayment.
If the debt arises from your trade or business, it can generally be deducted as an ordinary loss.
Even a partial loss may be deductible as long as you can document the partial worthlessness in your books.
If you’re using accrual accounting: once the debt becomes worthless, you may claim the deduction in the year’s worthlessness is established.
If you use cash-basis accounting, you generally cannot deduct bad debts for income that were never actually recognized.
Debts that are personal or not related to a business are treated differently. To deduct a nonbusiness bad debt, the debt must be totally worthless; partial write-offs aren’t allowed. If deductible, such a loss is treated as a short-term capital loss, subject to the usual capital-loss limitations (e.g. up to $3,000 per year offsetting ordinary income; the rest carries forward).
You should be prepared to establish that the debt is uncollectible. This includes:
Documenting all collection efforts from demand letters, dunning notices, phone calls, emails showing persistent follow-up.
Demonstrating a significant event (e.g. debtor bankruptcy or death), or other facts indicating no possibility of repayment.
Keeping clear bookkeeping to show the debt was genuine (loan or receivable), not a gift or capital contribution.
If you can’t establish worthlessness or fail to properly document, the deduction may be disallowed especially for nonbusiness or familial loans.
The loss should be claimed in the year when the debt becomes worthless (or when worthlessness is determined).
For business debts using accrual accounting, this often means the year you write the debt off.
If you fail to claim it in the correct year, you may still be able to amend within an extended statute of limitations: under certain tax code provisions, bad-debt deductions can be claimed up to seven years from the original return due date.
A debt must be legitimate: loans to friends or family without formal documentation (promissory note, repayment terms, interest, etc.) are often recharacterized as gifts and aren’t deductible.
For nonbusiness debts, you cannot deduct partial losses. The debt must be entirely worthless for the deduction to apply.
Cash-basis taxpayers typically cannot deduct unpaid invoices or unpaid fees because they never included that amount in income; thus, no basis exists for a bad debt deduction.
If the debt has any expectation of repayment or if collection efforts haven’t been adequate, claiming a deduction too early may result in a denial by tax authorities.
Bad-debt deductions can provide meaningful tax relief but only when the debt is real, documented, judged uncollectible, and handled properly for tax purposes. Business bad debts enjoy the most favorable treatment (ordinary loss, ability to deduct partial losses), while personal/nonbusiness debts require total worthlessness and are limited to capital-loss treatment. Strong documentation and timely action are your best defense against IRS challenges.
Before you enter into a business or nonbusiness loan, always seek professional tax advice. Inadequate attention to the relevant rules can lead to unintended and unfavorable tax consequences. For example, the IRS may claim that an ill-fated advance should be classified as a personal gift or a capital contribution, which can't be written off as a bad debt loss.
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