There are times in life when you lend someone money. Unfortunately, there are nearly as many times that they don’t pay you back. But all is not lost if you can't collect on a debt you're owed, as the IRS offers allowances for "bad debt."
Of course, there are some stipulations as to what you can consider a bad debt, but there are generally two types of debts: business and non-business.
Let’s look closer at both:
Bad Business Debts
A business debt must originate from trade or transaction that’s closely tied to your vocation or business. The debt must have been issued for some sort of business-related motive (not just lending a family member, etc.) and the debt must have gone worthless due to non-payment.
For instance, valid bad debts may include business loan guarantees, credit sales to clients, or other loans to employees, vendors, suppliers, or even customers.
At that point, you can deduct the bad debt on your:
· Schedule C (Form 1040 or 1040-SR)
· Profit or Loss from business (for sole proprietorship)
· On your applicable business tax return
The business would deduct those bad debts – whether in part or in full – from their gross income when we calculate its taxable income.
However, remember that you can’t just consider any loss a debt – it typically has to be previously accounted for. It also may not be a gift or a loan that was made without the expectation of repayment.
Bad Non-business Debts
Aside from business transactions and dealings, you may lend someone money and that debt becomes worthless. However, unlike business bad debt, you cannot deduct a partially worthless nonbusiness debt. But when there no longer is a reasonable expectation that you’ll be repaid, it becomes a bad debt by IRS standards.
But first, you must have made reasonable steps to collect that debt, but that doesn’t necessarily have to be official court documents. Once the debt is considered worthless, you may take the deduction only in that same year that it became worthless.
A bad non-business debt will be reported as a short-term capital loss on Form 8949, Sales and Other Dispositions of Capital Assets. We’ll need to attach a separate statement that lists information like:
· Description of debt
· Amount owed
· Date it became due
· Name of debtor
· Disclose any familial or business relationship between you and the debtor
· Document your efforts to collect on the debt