When you loan someone money and that person is unable to pay you back, the result is “bad debt.” Tax law does provide some relief by allowing taxpayers to take certain deductions for these bad debts to offset against income.
There are essentially 2 types of bad debts:
- Business bad debts, and
- Nonbusiness bad debts.
The treatment of business bad debts is more favorable than nonbusiness bad debts.
A business bad debt, like its name, is a bad debt that arises from the taxpayer’s trade or business (e.g., a computer retailer sells computer on credit, and the buyer defaults on the loan).
Business bad debts are deductible by the taxpayer at any time when they become:
- Completely worthless (i.e., cannot be recovered); or
- Partially worthless.
Generally, a business bad debt deduction is a business expense deduction and may be used to offset other ordinary business income without any limitations.
A taxpayer is not required to take a deduction for a business bad debt when it is only partially worthless and may wait until the bad debt is entirely worthless to take the deduction.
A nonbusiness bad debt is a debt that is personal in nature and not related to a trade or business (e.g., you loan your friend some money and he cannot pay you back).
Nonbusiness bad debts are deductible only when they become completely worthless. They are treated as short term capital loss to the taxpayer, so they can only be used to offset capital gains and up to $3,000 of noncapital income for individuals.
Normally, when the person to whom you lent money firmly notifies you that he/she cannot pay you back, then your debt is probably worthless. However, when no such clear response is obtained, determining if your debt has turned “bad” becomes a facts and circumstance issue. Usually, if there are good signs that lead you to believe you will never get your money back, then you can treat that as a bad debt.
Tax laws are complex and ever-changing. Although there are various tax preparation softwares on the market that may help you with your tax problems, they cannot provide the safme level of service that an experienced and knowledgeable tax attorney can. If you are unsure about the characterization of your expenses or if you need someone to represent you before the IRS, a tax attorney can help you.