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

To deduct a bad debt, you must have a basis in it - that is, you must have already included the amount in your income or you loaned out your cash. 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 reported as a short-term capital loss in Part I on Schedule D, Form 1040. 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. A non-business bad debt deduction requires a separate detailed statement attached to your return.

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

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