What Is a Tax Impact of Writing off Bad Debt?

by Michael Keenan
Different types of bad debt have different rules.

Different types of bad debt have different rules.

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When you make a loan, either personally or as part of your business, you expect to be repaid. However, not all loans turn out well. When debt goes bad, the Internal Revenue Service permits you to claim a deduction on your income taxes. Bad debt is treated differently depending on whether it comes from your trade or business or a personal debt.

Business Versus Non-Business Debts

Business debts refer to debts made as part of the course of business, such as loans made to customers, sales on credit or guarantees of business loans. You can't treat a contribution of capital to a company as a bad debt in the event that the investment does not perform well. The IRS permits you to deduct business bad debts partially or fully in the year that the debt becomes worthless. If you make payments under a business loan guarantee, you can deduct those payments in the year you make them, unless you still have rights to recover those payments from the original debtor.

Methods for Business Bad Debt Deductions

The IRS recognizes both the specific charge-off method or the nonaccrual-experience method. The specific charge-off method allows you to write off debts in full or in part as they become uncollectible. The nonaccrual-experience method only applies to companies with service-related income that meets the gross receipts test, which requires the average annual gross receipts for any three-year period to fall below $5 million. Under this method, you do not recognize income that you expect to be uncollectible.

Personal Bad Debt

Personal bad debts include any debts that do not qualify as business debts and the debt must be from money that you already included in income. For example, you could not claim a personal bad debt expense for your neighbor not paying you for taking care of his pets while he was on vacation. When claiming a personal bad debt, you must show that it was intended to be repaid. Otherwise, the IRS considers it a gift. For example, if you give money to your friend, you must show that it was a loan to claim a deduction for your friend not being able to pay you back. Personal debts can only be written off in whole when the entire debt is bad; no partial deductions are permitted.

Deducting Personal Bad Debt

The IRS categorizes debt as "worthless" if the surrounding circumstances show there is no reasonable expectation of repayment. You can show a debt is worthless by exhausting your reasonable recovery options, such as pursing a judgment from a court. However, going to court is unneeded if you can show the debt is uncollectible. In addition, you do not have to wait until the debt is due. For example, if an unsecured debtor files bankruptcy three years before a payment is due, you do not have to wait until the debt comes due to find the debt is worthless. You can deduct the debt in the year it becomes worthless. Personal bad debt is written off as a short-term capital loss on Schedule D. Since it counts as a short-term capital loss, it is subject to the annual limit on capital losses.

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