What bad debts may I deduct on my federal personal income tax return?

What is a bad debt?  A bad debt is a debt that has become completely uncollectable.  For example, Mr. Jones owes you $10,000 and he stops making the monthly payment.  You take him to court and win a judgment.  If Mr. Jones dies before you can collect on the judgment, and he leaves no estate, that debt becomes uncollectable and is therefore a bad debt.

There are two types of bad debt that are deductible on a personal income tax return: business bad debt and non business bad debt.

Business bad debts

Deductible business bad debts are debts that became worthless in the year they were to be deducted.  The requirements for the business bad debt are:

That they are incurred in the taxpayer’s trade or business, or were debts created or acquired in such trade or business.

Example: One of your customers has an account with you and files bankruptcy.  You do not receive any of the proceeds of the bankruptcy because they all go to higher priority creditors. That becomes a business bad debt.

Business bad debts would be deductible on Schedule C.

Nonbusiness bad debts

Non-business bad debts are deductible if they meet the following qualifications:

–The debt is a formal debt for which the debtor is legally obligated.

–The debt is totally worthless.

–It must be money that you actually loaned out from funds previously taxed.

Example:  If you loan your brother $5000.00 and have him sign a contract to repay the debt, it is a legal debt.  If your brother never repays you and you cannot sue him to obtain repayment, or you sued him but are unable to collect, that is a deductible, non-business bad debt.

However, if you are allowing your brother to live in your home, paying rent, and you eventually kick him out because he wasn’t paying the $400.00 a month rent, that is not a deductible non-business debt.  That would be income that you have not yet collected. Therefore money that was not previously taxed.

Example:  You have a good friend who is struggling and you decide to loan your friend $2000.00 to help them get caught up with their bills.  You do not sign any paperwork and there is no proof that you made the loan.  Your friend pays you back some of the money, over time, but after a while you simply do not hear from your ex friend.  You are unable to sue your friend because you have no proof of the debt, and you are also unable to claim a non-business bad debt because the loan was never something that your friend was legally obligated to repay.

Report a nonbusiness bad debt on Form 8949, Sales and Other Dispositions of Capital Assets.  Attach a bad-debt statement to your tax return explaining the details of the loan you made.

Case Studies: Deductible Bad Debts on Federal Personal Income Tax Return

Case Study 1: Business Bad Debt

John owns a small business and provides goods to various customers on credit. One of his customers, ABC Company, files for bankruptcy, and John does not receive any payment from the bankruptcy proceedings due to higher priority creditors. As a result, the debt owed by ABC Company becomes a business bad debt for John.

Case Study 2: Non-business Bad Debt

Sarah lends $5,000 to her brother, Mike, who signs a contract promising to repay the debt. However, Mike fails to honor the agreement, and Sarah is unable to sue him or collect the amount owed. In this situation, the debt becomes a non-business bad debt since it meets the requirements of being a formal debt, totally worthless, and funds that were previously taxed.

Case Study 3: Non-deductible Non-business Debt

Jennifer allows her friend, Lisa, to live in her apartment and pays rent. However, Lisa consistently fails to pay the $400 monthly rent and is eventually evicted. The unpaid rent cannot be considered a deductible non-business bad debt because it represents income that Jennifer has not yet collected, rather than a formal debt.

Case Study 4: Unverifiable Non-business Bad Debt

Mark lends $2,000 to his friend, Alex, to assist him with his financial difficulties. Although there was no written agreement or proof of the loan, Alex initially repays some of the money. However, he eventually disappears, and Mark is unable to sue him due to the lack of evidence. Since the loan was not legally documented, Mark cannot claim a non-business bad debt deduction.