Bad Debt Losses: Can You Deduct Loans Gone Bad?

Posted on June 19th, by Hoberman & Lesser in Timely Articles.

The IRS is always skeptical when individual taxpayers claim deductions for bad debt losses. Why? Losses from purported loan transactions often fail to meet the tax-law requirements for bad debt loss deductions.

For example, a taxpayer might try to write off a capital contribution to a business entity that underperformed. Or a taxpayer might have advanced cash to a friend or relative with the unrealistic hope that the money would be paid back, but nothing was put in writing.

To claim a deductible bad debt loss that will survive IRS scrutiny, you must first prove that the loss was from a legitimate loan transaction gone bad — not merely some other ill-fated financial move. Then, you must make another important distinction: Is it a business or nonbusiness bad debt?

Business Bad Debts

Bad debt losses that arise in the course of the taxpayer’s business are treated as ordinary losses. In general, ordinary losses are fully deductible without any limitations. In addition, partial deductions can be claimed for business debts that partially go bad.

An exception to these general rules occurs when a taxpayer makes an uncollectible loan to his or her employer that results in a business bad debt loss. Under IRS rules, this type of write-off is classified as an unreimbursed employee business expense, which is combined with other miscellaneous itemized deductions (such as investment expenses and tax preparation fees) and is deductible only to the extent that the total exceeds 2% of the taxpayer’s adjusted gross income. In addition, miscellaneous itemized deductions are completely disallowed if you are liable to pay the alternative minimum tax. Unfortunately, this unfavorable exception has been upheld by previous U.S. Tax Court decisions.

Nonbusiness Bad Debts

Bad debt losses that don’t arise in the course of an individual taxpayer’s business are treated as short-term capital losses. As such, they’re subject to the capital loss deduction limitations.

Specifically, taxpayers who incur a net capital loss for the year can deduct up to $3,000 (or $1,500 for those who use married filing separately status) of the net loss against income from other sources (such as salary and self-employment income). Any remaining net capital loss is carried over to the next tax year.

So, if you have a major nonbusiness bad debt loss and capital gains that amount to little or nothing, it can take several years to fully deduct the bad debt loss. In addition, losses can’t be claimed for partially worthless nonbusiness bad debts.

Consult with Your Tax Professsional

Before you enter into a business or nonbusiness loan, always seek professional tax advice. Inadequate attention to the relevant rules can lead to unintended and unfavorable tax consequences. For example, the IRS may claim that an ill-fated advance should be classified as a personal gift or a capital contribution, which can’t be written off as a bad debt loss. Contact us if you have any questions.