The Internal Revenue Service (IRS) allows taxpayers to deduct qualified uncollectible loans as business or non-business bad debts pursuant to the Internal Revenue Code. Bad debts are uncollectible loans, which become worthless or partially worthless. Generally, taxpayers can deduct business bad debts more easily than they can deduct personal or non-business bad debts, since the IRS allows you to partially deduct an unpaid business debt, but you cannot take a partial deduction for a non-business loan -- your personal loan must be totally uncollectible. To deduct bad debts, you must have a bona fide debt or obligation allowing you to collect or force repayment, and any other type of payment may be considered a nondeductible gift.
Business Bad Debts
Verify your loan is valid and legally enforceable as a loan obligation. Generally, you must have included your debt as income or provided cash to a borrower as a loan. Types of business debts include business loans, credit extensions to clients or customers, or loans to suppliers.
Download Schedule C of IRS Form 1040, Profit or Loss From Business.
Include the amount of your bad debt on Part V, Other Expenses, of Schedule C. You can include partial bad debts or completely worthless debts once you are certain that your debts have become partially or completely worthless.
Non-business Bad Debts
Verify your loan is valid and legally enforceable as a loan obligation. The IRS requires that there be an oral or written obligation for a borrower to repay your debt. If you do not have a written loan agreement, it will be harder for you to prove that your loan was not a gift. You cannot deduct a gift. Generally, the IRS looks at all of the facts and circumstances of your oral agreement if you do not have a written instrument.
Download Schedule D of IRS Form 1040, Capital Gains and Losses.
Report your worthless loan or debt as a non-business bad debt on Form 1040, Schedule D.
Report your uncollectible loan in Part 1, Short-Term Capital Gains and Losses.
Attach a detailed summary or statement of the facts pertaining to your uncollectible loan. You must include information pertaining to your loan, including the borrower's name, loan amount and date of your loan.
The IRS has rules regarding the timing for bad debt deduction for accrual- versus cash-basis accounting method taxpayers. Generally, if you did not report your loan as income, you cannot deduct it. Thus, if you never collected the debt, you may not be able to report it as a bad debt.
If you later recover or collect a previously deducted bad debt, you must report it as income in the year that you collected it.