Understanding Bad Debt Deduction

Bad debt deduction is a tax relief measure that allows individuals and businesses to write off debts that cannot be collected, thereby reducing their taxable income. Simply put, bad debt refers to money owed to you—such as unpaid loans, outstanding invoices, or other receivables—that you cannot collect despite reasonable efforts. For tax purposes, bad debt deductions are a way to recover some of the financial losses, but they must meet specific criteria to qualify under IRS rules.

To qualify for a bad debt deduction, the debt must be bona fide, meaning it arises from a valid and enforceable obligation to repay. This requires proper documentation and evidence of a debtor-creditor relationship. For example, a personal loan to a friend without formal documentation is unlikely to qualify. Additionally, the debt must be entirely or partially worthless, and the creditor must demonstrate that they have made reasonable attempts to collect it, such as sending demand letters or pursuing legal action.

Corporate vs. Non-business Bad Debt

Business bad debts are related to a trade or business activity and are typically considered ordinary losses. Examples include unpaid accounts receivable or loans made during normal business operations. These losses directly reduce taxable income and are not subject to capital loss limitations. Non-business bad debts, such as personal loans to friends or family or personal investments that result in a loss are treated as short-term capital losses. These losses are subject to capital loss deduction limits, which allow individuals to deduct only up to $3,000 annually, with the remaining loss carried forward to future years.

What Happens to Securities in Bad Debt Cases?

Securities like stocks and bonds are treated differently from other types of bad debt. If a security becomes completely worthless, it is treated as a capital loss on your tax return. Capital loss rules govern these losses and are deemed to have occurred on the last day of the tax year.

The worthlessness of a security must be established with certainty, such as evidence of the company by demonstrating that the issuing company is insolvent, has ceased operations, or has no remaining assets.

How is Worthlessness Determined?

You determine worthlessness by evaluating the debtor's financial condition (e.g., insolvency or bankruptcy), your efforts to collect the debt, and the lack of potential recovery. You must claim this deduction the year the debt became worthless, not when you suspect it may become uncollectible. Properly documenting the debt and its worthlessness ensures you don’t lose the deduction.

We work with our clients to help them understand the rules surrounding bad debt deductions. Consult Cambaliza McGee LLP for personalized guidance to ensure you comply with the latest tax laws.