What Is a Bad Debt Deduction?
If someone owes you money that you’re unable to collect, you may have a bad debt. To claim a deduction for it, you generally must have either:
Previously included the amount in your income, or
Loaned cash with the expectation of repayment.
If you’re a cash-method taxpayer (which most individuals are), you typically cannot claim a bad debt deduction for unpaid wages, salaries, rents, fees, interests, dividends, or other similar types of taxable income.
To be eligible for the deduction, you must demonstrate that you intended the transaction to be a loan rather than a gift at the time it was made. For instance, if you lend money to a friend or family member with the understanding that they may not repay it, the IRS considers it a gift, which is not deductible as a bad debt.
When Is a Debt Considered Worthless?
A debt is deemed worthless when the surrounding circumstances indicate that there is no reasonable expectation of repayment. To establish that a debt is worthless, you must show that you have made reasonable attempts to collect the debt.
However, you don’t need to file a lawsuit or obtain a court judgment if you can demonstrate that the debt would still be uncollectible, even with a court order. You are only allowed to claim the deduction in the year the debt becomes worthless—you don’t have to wait until the debt is due to determine its worthlessness.
Types of Bad Debts: Business vs. Nonbusiness
There are two categories of bad debts for tax purposes:
✅ 1. Business Bad Debts
A business bad debt arises from the worthlessness of a debt created or acquired in the course of operating a trade or business. The debt is considered business-related if your primary motive for entering the transaction was to further your business.
You can claim business bad debts on Schedule C (Form 1040), Profit or Loss From Business, or on your applicable business income tax return.
Examples of Business Bad Debts:
Loans made to clients, suppliers, distributors, or employees
Credit sales made to customers
Business loan guarantees
You can deduct business bad debts, either in part or in full, when calculating your gross income. For more details, refer to Publication 334.
🚫 2. Nonbusiness Bad Debts
All other types of bad debts are classified as nonbusiness bad debts. To be deductible, a nonbusiness bad debt must be considered completely worthless. You cannot deduct a partially worthless nonbusiness bad debt.
To report a totally worthless nonbusiness bad debt:
Use Form 8949, Sales and Other Dispositions of Capital Assets.
Report it as a short-term capital loss on Part 1, line 1.
In Column (a), write the debtor's name and include the note: "bad debt statement attached."
In Column (e), enter your basis (the amount of the debt).
In Column (d), enter zero.
Use a separate line for each bad debt.
Nonbusiness bad debts are subject to capital loss limitations. You must also attach a detailed statement to your tax return, including:
A description of the debt (amount and due date)
The name of the debtor and your relationship (if any)
The collection efforts you made
The reason you believe the debt is worthless
For further details on nonbusiness bad debts, consult Publication 550.
Additional Information and Resources
For a deeper dive into bad debt deductions and related rules, refer to:
Publication 550 – Investment Income and Expenses
Publication 334 – Tax Guide for Small Business (For Individuals Who Use Schedule C)