General

• The IRS recognizes two types of bad debt: debt resulting from business loans, or debt resulting from non-business loans. Business bad debt results from the operation of a trade, and is deducted on the income tax filed by the business or, for sole proprietors and single-member limited liability companies, on Schedule C of Form 1040. Non-business bad debt, conversely, occurs outside of the operation of a trade or business, is not subject to self-employment tax deductions, and can be deducted directly on Schedule D of Form 1040.
  
  

Deductible Amount

• The IRS allows taxpayers to deduct the full non-recoverable amount of both business and non-business loan principal for cash loans. Business loans may be deducted when a portion of the loan becomes noncollectable. Non-business loans are only deductible when the entire loan becomes fully noncollectable. Accumulated or accrued interest on the loans is only deductible to the extent it has been previously recognized as interest by the taxpayer.
  
  

Example

• Assume individual income taxpayer A lends $1,000 to a former colleague who is out of work. Taxpayer A charges a 4 percent rate of interest on the loan. At the end of year one, $40 in interest has accrued on the loan. During year two, the former colleague passes away and taxpayer A determines he cannot collect from the colleague's estate. Taxpayer A can write this loan off as a non-business bad debt. The amount of the deduction depends on whether Taxpayer A reported the $40 as interest income on his tax return in year one. If so, he may deduct $1,040 on his tax return for year two. If not, his deduction is limited to $1,000.
  
  

Capital Loss Rules

• For individual income tax payers, the Internal Revenue Code limits capital losses not offset by capital gains to $3,000 annually. Since the IRS requires these taxpayers to deduct bad debts as a short-term capital loss, non-business bad debt deductions are subject to the same limitations. As a result, taxpayers without other capital gain income may not deduct losses beyond $3,000 annually. Amounts not deductible in a current year may be carried forward and deducted in future tax periods, subject to the same $3,000 limitation.
  
  

Warning

• The IRS looks closely at non-business bad debts to friends and family members to ensure they are truly bad debts and not actually disguised gifts. Before allowing a deduction, the IRS may look for evidence of attempts to collect the debt. If the IRS determines the taxpayer did not make reasonable efforts to collect the debt, the entire amount of the deduction may be denied.