If someone owes you money that you cannot collect, you have a bad debt. There are two kinds of bad debts - business and nonbusiness.

Bad debts are deductible only when the amount owed has been previously included in your income. If you are a cash basis taxpayer, as most individuals are, you may not take a bad debt deduction for expected income you have not received, because it was never included in your income. A business bad debt, generally, is one that comes from operating your trade or business. A business deducts its bad debts from gross income when figuring its taxable income. Business bad debts may be deducted in part or in full.

All other bad debts are nonbusiness. Nonbusiness bad debts must be totally worthless to be deductible. You cannot deduct a partially worthless nonbusiness bad debt. You must establish that you have taken reasonable steps to collect the debt and that the debt is worthless. It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. You may take the deduction only in the year the debt becomes worthless. A debt becomes worthless when there is no longer any chance the amount owed will be paid. You do not have to wait until the debt comes due.

A nonbusiness bad debt is deducted on Schedule D (Form 1040) as a short-term capital loss. It is subject to the capital loss limit of $3,000 per year. This limit is $1,500 if you are married filing a separate return.

For more information on nonbusiness bad debts, order Publication 550, Investment Income and Expenses. For more information on business bad debts, order Publication 535, Business Expenses. Publications can be ordered by calling 1-800-829-3676, or downloaded from this web site.

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