Tax Deductions for Non-business Bad Debts
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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 initially the intent might have been good, there are times when things don’t go according to plan. The payments stop coming, and eventually, you realize you’re never going to see your money again.
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 a substantial sum, it’s possible to write off the money in the year the debt becomes uncollectible.
Identify if it’s nonbusiness or business bad debt.
Business bad debt is exactly how it sounds – debt that comes 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 he or she never repays you, that’s a nonbusiness bad debt.
Determine if you can claim the bad debt on your tax return.
In order to claim a nonbusiness bad debt as a deduction on your tax return, the debt must have been declared completely uncollectible.
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 nonbusiness bad debt becomes uncollectible, it is then 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 guaranteed a debt as a friend, with no consideration in return and the debt goes bad, it is then considered a gift instead of a loan. And as you may be able to guess, gifts can’t be used as a write-off on your tax return as nonbusiness bad debt.
Document your bad debt.
To take a tax deduction for bad debt, you must show that you had a legal debt and you cannot collect on it. Be sure to keep track of the following information:
- Note or 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, it will be determined 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 his or her business information or relationship with you.
- Records showing your basis in the debt. Keep a record of the amount of money you loaned. You can’t take a bad debt deduction for 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.
- Additional documentation indicating why the debt is worthless. For example, if the borrower went bankrupt, you’ll want to keep that documentation. You can only deduct debts if they are totally worthless.
Enter the bad debt on your tax return.
While having bad debt is never a good situation to be in, you do have a few options to help offset the loss.
But, there are a couple details to pay attention to.
In order 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 need hard evidence to prove the repayment was understood by all parties, and the debt must be declared totally worthless.
If you are able to claim the bad debt on your tax return, you’ll need to complete Form 8949, Sales and Other Dispositions of Capital Asset.
The bad debt will then be treated as short-term capital loss by first reducing any capital gains on your return, and then reducing up to $3,000 of other income, such as wages.
If you cannot take the full deduction in the year of the loss, you can carry it forward to later years.
If you’ve already filed a return for the year in which the debt became worthless, file Form 1040X, Amended U.S. Individual Income Tax Return, with Form 8949.
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 happens if a bad debt comes back to life?
Let’s 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 to you.
However, you’ll only have to pay income tax on the amount of bad debt that actually reduced your tax.
This could end up being less than the amount you deducted when you filed your return with the bad debt deduction.