Everyone should be paid what they’re rightly owed. Unfortunately, bad debt still happens. If you’re in this type of situation, the tax ramifications can go one of two ways. They’ll either work in your favor to lower your tax liability. Or you could end up in an even worse situation. It all depends on whether you’ve done your “homework.” Follow these tips to figure out whether you’ll qualify for tax relief!
Tax Code for Business Bad Debt
The IRS deals with bad business debt and bad non-business debt in different ways. For business owners, the bad debt tax classification would be applied to their business tax deductions. In order to qualify as a deduction, though, the tax code says that the amount of debt (whether partially or entirely) must have already been included as business income or a business asset. After all, there’s no reason why you should pay tax on an amount you’ve reported as income but haven’t actually received.
Business owners must also be able to show proof that multiple efforts have been made to collect on the debt. Creating a summary of these attempts will work to support your claim that the debt should be considered worthless.
Non-Business Bad Debt Reporting
When the debt can’t be defined as business-related, taxpayers will only be able to deduct bad debt that is 100 percent worthless. The IRS does not allow partial deductions.
What’s more, non-business bad debt must also be related to a true loan. Many people need to be careful about how this is reported because loans made to family members can often be interpreted as a gift, not a loan that’s intended to be repaid. The most effective way to prove this to the IRS is to have a signed agreement.
By determining that the bad debt is valid and can become a deduction, you will report the amount as a short-term capital loss. This also means that the loss will be subject to any capital loss limitations for the year.
In addition, you will need to submit a statement along with your return that includes a description of the debt and its amount, the date when it was due, the debtor’s name, any business or family relation to your debtor, as well as the details on your efforts to collect the debt and, subsequently, why you’ve decided the debt has become worthless.
Going to the trouble of preparing these documents can be a hassle, but it can really pay off in the end. A significant loan with bad debt shouldn’t be held against you on your return.
Need Help with Your Tax Prep?
If it’s become clear to you that the debt won’t be paid to you, navigating your tax return and your correspondence with the IRS won’t exactly be clear-cut. Let’s find out whether you can write off that debt for a tax deduction!
NSO & Company helps clients with tax planning services year-round. You don’t need to wait until tax season to figure out how to deal with bad debt. Together, we can set up the right plan of action to make sure your tax situation is fair—especially when you’re already stuck with having to forgive debt.