Tax Insights

Your Guide to State, Local, Federal, Estate + International Taxation

Bad debts. Can you take the deduction?

net operating lossHave you ever lent money to another person or entity and quickly realized you’re never going to get it back – either personally or from your business? First, the concern was how to get the money back. Then, the money you loaned in good faith turned out to be a bad debt. There are a few instances in which you can get a tax deduction for debts that become worthless in a taxable year.

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There are certain rules enforced to be able to deduct a bad debt. There has to be a debtor-creditor relationship that involves a legal, valid and enforceable obligation to pay the money back. There must also be an intent to enter the relationship which is established by having an actual expectation of repayment and intent to enforce the debt if necessary. A formal loan agreement does help prove the intent of a loan relationship but does not always guarantee the debt is deductible.

If the loan was made to a related party, you will want to prove the loan was made for legitimate business purposes as well as the other tests listed above. The IRS will examine deductibility of related party bad debts more closely than others.

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A bad debt deduction can only be taken if there was an actual loss of money or if the amount was reported as income. A business bad debt (a debt that the dominant motivation of the debt was related to your business) can be fully or partially worthless; whereas, a nonbusiness bad debt (a debt that is personal in nature) must be fully worthless in the year the deduction is taken. The bad debt deduction is taken when worthlessness can be established.

A bad debt deduction cannot be taken if you do not have any records or activity to prove there was an enforceable loan entered into for profit. It is very important when lending money to another person to make sure you have it documented in the event it becomes uncollectible.

If you think you may be eligible for a bad debt deduction, check with your tax professional to see if you meet the requirements.

KC Kolb, CPA