Does someone owe you money? If so, deduct it!
The IRS allows individuals who are owed money to deduct a bad nonbusiness debt and have no hope of collecting.
However, before you start deducting every debt you have been owed since grade school, you should know a few of the requirements.
It must be a loan
To deduct the debt, it must have been a loan at the time of the transaction. Therefore, at the time the money was given, there has to have been a clear understanding that the money would be repaid at a later time.
For this reason, many debts do not qualify for the deduction. For example, if you gave money to a close relative with the option of having the relative repay you, the amount is considered a gift and not a loan. In this instance, you would be unable to take the deduction.
It is totally worthless
To deduct a nonbusiness bad debt, the IRS also requires the debt to have become "totally worthless." The IRS defines such a debt as one where "the surrounding facts and circumstances indicate there is no reasonable expectation of payment."
You do not have to wait until the loan is due in order to take the deduction. If there is evidence the person will be unable to pay you back due to a bankruptcy, foreclosure or other adverse financial event, you will be allowed to take the deduction when the debt becomes worthless.
Although the IRS does not require you to file a lawsuit against the person who owes you, it does require you to prove that you have taken measures to be repaid.
You may take the deduction only in the year the debt becomes totally worthless.
A nonbusiness bad debt expense is reported on your tax return as a short-term capital loss. In addition, you have to provide the IRS with additional information concerning the debt, such as a description, the name of the debtor, efforts you have taken to collect and why you believe it is worthless.
For more information, visit the IRS website and review Publication 550, Investment Income and Expenses.
Kemberley Washington is a certified public accountant and professor at Dillard University in New Orleans. She writes a personal finance blog at Kemberley.com. Follow her on Twitter at @kemwashcpa.