Written by Marc R Barnes EA
September 25, 2009
To deduct a bad debt, you must have previously included the amount in your income or loaned out your cash.

If you are a cash basis taxpayer, as most individuals are, you may not take a bad debt deduction for money you expected to receive but did not (for example, for money owed to you for services performed, or rent) because that amount was never included in your income. For a bad debt, you must show that there was an intention at the time of the transaction to make a loan and not a gift. If you lend money to a relative or friend with the understanding that it may not be repaid, it is considered a gift and not a loan.

There are two kinds of bad debts – business and nonbusiness. A business bad debt, generally, is one that comes from operating your trade or business. A business deducts its bad debts from gross income when figuring its taxable income. Business bad debts may be deducted in part or in full. All other bad debts are nonbusiness. Nonbusiness bad debts must be totally worthless to be deductible. You cannot deduct a partially worthless nonbusiness bad debt

A debt becomes worthless when the surrounding facts and circumstances indicate there is no longer any chance the amount owed will be paid. To show that a debt is worthless, you must establish that you have taken reasonable steps to collect the debt. It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. You may take the deduction only in the year the debt becomes worthless. You do not have to wait until a debt is due to determine whether it is worthless.