Do you want to legally deduct bad debts from your tax return? If YES, here are 7 smart tips on how to deduct and report bad business debt on 1040 tax return.

There are many reasons why you may want to make a loan to someone. But the truth is that you may not get paid in all cases. In some cases, the debtor plans to pay back but cannot due to circumstances beyond their control. However, there are times when the debtor is strongly determined not to pay back.

If you offer a loan to someone you know and that person fails to pay back, you may have a bad debt. And you can deduct the amount from your taxes as a bad debt. This is a smart way to recover some of your losses.

What is a Bad Debt?

You have a bad debt when someone owes you money and you cannot collect it because the debtor is unable to pay back. There are two types of bad debt:

  • Business bad debts
  • Non-business bad debts

You have a business bad debt when the debt is related to your business, such as when you lend money or give goods on credit to a trusted customer who fails to pay back for whatever reason. Any other type of bad debt that is not related to your business falls under non-business debts, such as the money you lend to friend or a relative. In certain situations, you can take a tax deduction when the debt isn’t paid.

For example, you are a self-employed freelance writer, and you lend your aunt some money so she can pay her rent. If you cannot get the money back, it’s deductible only if it qualifies as a non-business debt. That’s because you are not in the money-lending business, and the loan isn’t connected to your business. From this point, we will be discussing business bad debts.

Requirements for Business Bad Debt Deduction

Aside the requirement that the debt must be connected to your business, to deduct a business bad debt, the following requirements must be met.

  • The debt must be bona-fide
  • You must have a basis in the debt
  • The debt must have been rendered worthless in the year you claim the deduction

Requirement 1: The debt must be bona-fide

A bona-fide debt is one regarding which there is a debtor-creditor relationship and there is a valid and enforceable obligation for repayment. In other words, the money you gave the borrower must have been a legitimate loan, not a gift.

If you lend out the money with the understanding that it needs not be repaid, that’s a gift, and it doesn’t qualify for a bad debt deduction even if you later change your mind to get the money back. To deduct bad debt from your income tax return, you will be required to provide proof that the debt is indeed a bona fide one. This proof could be written promissory note signed by the borrower. Interest is another proof that the IRS accepts to regard a debt as a bona fide loan. Non-interest loans look like gifts to the IRS.

Requirement 2: You must have a basis in the debt

Having a basis in the debt means you must have some real investment in the debt. That is, you have already included the amount in your business records or loaned out the cash. So, for example, you cannot claim a bad debt deduction for court-ordered child support not paid to you by your former spouse. And you cannot take a bad debt for unpaid salaries, wages, rents, fees, interest, dividends, and similar terms.

Requirement 3: The debt must have been rendered worthless

To be deductible, the business bad debt must be worthless. “Worthless” means the debt cannot be collected again even after you have taken reasonable steps and given enough time to collect the debt. Now, you don’t have to sue the borrower just to establish proof that the debt is worthless. All you have to do is show that there is no longer any chance that the debt will be repaid.

How to Deduct and Report Bad Business Debt on 1040 Tax Return

You can deduct bad debts on Schedule D of your Form 1040. You will be required to provide the debtors’ name and the amount of the bad debt. If you are reporting multiple bad debts, use a separate line for each bad debt.

For each bad debt you are reporting, attach a statement containing a description of the debt, the amount and date it became due, the name of the debtor, the family or business relationship between you and the debtor, the efforts you made to collect the debt, and an explanation of why you think the debt was worthless.

However, you must bear in mind that you can take business bad debt deduction only in the year in which the debt becomes worthless.

Ajaero Tony Martins