If someone owes you money that you cannot collect, you may have a bad debt.
For a discussion of what constitutes a valid debt, refer toPublication 550 (PDF), Investment
Income and Expenses, and Publication 535 (PDF), Business Expense. To
deduct a bad debt, you must have previously included the amount in your income.
If you are a cash basis taxpayer, as most individuals are, you may not take
a bad debt deduction for income you expected to receive but did not, such
as unpaid child support, rents or wages, because the amount was never included
in your income.
There are two kinds of bad debts - business and nonbusiness. 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 the surrounding facts and circumstances indicate there
is no longer any chance the amount owed will be paid. You do not have to wait
until a debt is due to determine whether it is worthless.
A nonbusiness bad debt is reported as a short-term capital loss in
Part 1 on Schedule D, Form 1040 (PDF). 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 nonbusiness bad debt deduction
requires a separate detailed statement attached to your return.
For more information on nonbusiness bad debts, refer to Publication 550 (PDF), Investment
Income and Expenses. For more information on business bad debts, order Publication 535 (PDF), Business Expenses.
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