Imagine you’re a small-business owner who decides to loan another business (or an individual) money. This would result in a business debt that is owed to you, presumably along with some interest and fees.
What happens if this business loan is never repaid? In that case, you would likely want to find a way to turn this scenario around with a bad-debt deduction on your taxes that lets you regain at least some of the money you lost.
But can you write off an unpaid loan? And how does a bad-debt tax deduction work?
What is a bad debt?
Before you move forward with a bad-debt tax deduction, it’s important to understand what “bad debt” really is. Generally speaking, a bad debt is a loan that was made with the intention of being repaid but which is now uncollectable.
There is also an essential distinction between business debt and nonbusiness debt. According to the Internal Revenue Service (IRS), business debts come from operating your business, while nonbusiness bad debts are debts for which the primary motive for incurring the debt was not business-related.
Examples of business bad debts from the IRS include:
- Loans your business made to clients, distributors, employees or suppliers.
- Sales to customers made on credit.
- Business loan guarantees.
For instance, a business owner may decide to loan money to a client who claims they are expanding their business in a way that might lead to more sales for you later on. The business owner may offer the client a business loan with a contract that explains how they’ll repay the money over time, as well as interest and fees they’ll pay along the way. If the client later shutters their business, that loan may become a bad debt, because the client now no longer has the means to repay the loan.
An example of a nonbusiness debt is if you loan money from your personal bank account to a friend, who promises in writing to repay you. If that friend files for bankruptcy and can no longer reasonably pay you back, you now have a bad debt.
Before you can deduct a bad debt, however, this debt must be worthless. In other words, the debtor must have completely stopped making payments, and you must have the presumption that they’ll never pay you back.
The debtor filing for bankruptcy is an example of solid proof that a debt is worthless, but you could also move forward with a bad debt if the person has made no effort to repay their loan and if they’re not responding to inquiries or messaging you send them regarding their debt.
You also need to be able and willing to prove that the loan was not a gift. “If you lend money to a relative or friend with the understanding the relative or friend may not repay it, you must consider it as a gift and not as a loan, and you may not deduct it as a bad debt,” writes the IRS.
How to file a bad-debt deduction
Before you move forward with a bad-debt tax deduction, the IRS would like to see proof of collection efforts, such as any certified letters you sent asking for repayment. An exchange of emails could also work as evidence to support your claim.
For business bad debt, you will file your bad debt on Schedule C on your tax forms. For nonbusiness bad debts, you must complete Form 8949. You can use the loss to offset any capital gains you have in the year that the debt became worthless. If your loss exceeds your gain, you get the standard $3,000 deduction against non-capital gain income. Any unused loss carries forward as short-term capital loss.
When to consider deducting a bad debt
Christian Brim, CEO of Core Business and Financial Services, says that, given the variables involved in determining whether an expense is allowable for taxes for bad debts, you have some flexibility in your timing. For example, you may not feel ready to deem a debt “completely worthless” until you’ve waited long enough that you’re absolutely certain you’ll never be repaid.
“Assuming that you can deduct a debt in a specific year, it may make sense to delay or accelerate bad debt deductions as part of your overall tax planning strategy,” says Brim.
For example, you may want to time your bad-debt tax deduction around your anticipated income and expenses, as well as tax rates. Brim also notes that filing an extension can buy you time to see a substantial amount of the next tax year before you have to make a decision.
Featured image by mavo of Shutterstock.