Tax Deductions for Non-Business Bad Debts

Updated for tax year 2023.

Have you ever lost money to a loan you’ll never collect? If you answered yes, the good news is you’re not alone. Many of us have lent money to a friend or relative at some point. And while the intent might have been good, there are times when things don’t go according to plan. Sometimes, the payments stop coming, and eventually, you realize you’ll never get your money back.

While finding yourself in this situation is unfortunate, you may be able to take consolation in the form of a tax deduction — even if you don’t own a business. If the amount you lent was substantial, it’s possible to write off the money in the year the debt becomes uncollectible.

At a glance:

• Even if you aren’t a business owner, you might be able to write off bad debts.
• To take a non-business bad debt deduction, you must have documents showing you had a legal debt that is now uncollectible.
• TaxAct® can help you deduct non-business bad debts.

Step 1: Identify if it’s non-business or business bad debt.

Bad business debt is precisely how it sounds — debt from operating a trade or business. A non-business bad debt is basically anything else. If you loan money from your personal bank account to a family member and they never repay you, that’s a non-business bad debt.

Step 2: Determine if you can claim the bad debt on your tax return.

The debt must have been declared completely uncollectible to claim non-business bad debt as a deduction on your tax return. A debt becomes uncollectible after you have tried every reasonable way to collect on it and have been unsuccessful. It’s also deemed uncollectible if the borrower files for bankruptcy and the debt is discharged.

Once a non-business bad debt becomes uncollectible, it is considered completely “worthless,” meaning you have no chance of being repaid, and you can provide proof you guaranteed the debt to protect your investment. At that point, you can then deduct the bad debt on your tax return.

However, if you guarantee a debt as a friend with no consideration in return and the debt goes bad, it is considered a gift instead of a loan. And as you may be able to guess, gifts can’t be used as a tax write-off on your income tax return as non-business bad debt.

Step 3: Document your bad debt.

To take a tax deduction for bad debt, you must show that you, the lender, had a legal debt and cannot collect on it. Be sure to keep track of the following information:

• Note or loan agreement proving you had a legal, enforceable debt: You don’t need mountains of legal paperwork, but you will need to have at least one document showing there was an understanding with the borrower that you were to be repaid. Otherwise, the IRS will determine that you made a nondeductible gift. An oral agreement may be permissible, but a written one is always better.
• Name of the debtor: Be sure to include their business information or relationship with you.
• Records showing your basis in the debt: Keep a record of the amount of money you loaned. Note that you can’t take a bad debt deduction for certain money you never received, such as uncollected alimony.
• Documentation showing you tried to collect on the debt: Any letters, emails and notes from phone calls are examples of documentation that will work here.
• Additional documentation indicating why the debt is worthless: You can only deduct debts if they are totally worthless, so you’ll want any and all evidence showing the debt is worthless. If, for example, the borrower went bankrupt, you’ll want to keep that documentation to help prove that it’s a worthless debt.

Step 4: Enter the bad debt on your tax return.

While having bad debt is never a good situation, you have a few options to help offset the loss. There are just a couple of details to pay attention to.

To deduct a bad debt, you must have included the amount in your income or loaned out cash. For example, you cannot claim a bad debt for money you expected to receive for repairing your sister’s air conditioner, even if she promised to pay. You will need hard evidence, preferably in writing, to prove all parties understood the repayment obligations, and the debt must be declared totally worthless.

If you can claim the bad debt on your tax return, you must complete Form 8949, Sales and Other Dispositions of Capital Assets. The bad debt loss will then be treated as short-term capital loss on Schedule D by first reducing any capital gains on your return and then reducing up to $3,000 of other income, such as wages.

TaxAct can help walk you through taking a non-business bad debt deduction if you choose to file with us. We will ask you to attach a statement detailing a description of the debt, the debtor’s name and their relationship to you, the efforts you made to collect the debt and how you decided the debt was worthless.

If you cannot take the full deduction in the year of the loss, you can carry it forward to later years. You have seven years from the due date for your original tax return to file a deduction for uncollectible bad debts or two years from the date you paid the tax for that year, whichever is later.

What if I already filed my tax return for the year?

If you’ve already filed a tax return for the year in which the debt became worthless, you’ll need to amend your return by filing Form 1040-X, Amended U.S. Individual Income Tax Return, with Form 8949 attached to your amended return.

What happens if a bad debt comes back to life?

Say you’ve given up on getting paid back on a loan and decided to take a tax deduction for a non-business bad debt. If you later collect on that debt, part or all of the amount you received may be counted as taxable income. However, you’ll only have to pay income tax on the amount of bad debt that actually reduced your tax. This could be less than the amount you deducted when you filed your return with the bad debt deduction.

This article is for informational purposes only and not legal or financial advice.

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