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Tax Tip: Understanding Bad Debts

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Courtesy of Guest Blogger, Stanley J. Bushner, Shareholder, Buckno Lisicky & Company CPA's

CLICK HERE to learn more about Buckno, Lisicky & Company CPA's

There are two kinds of bad debts business and non-business (personal).   There is a big (tax) difference between business and non-business bad debts.   A business bad debt is an ordinary deduction and therefore can be offset against ordinary income.  A non-business bad debt is a short-term capital loss thus limited to $3,000 a year against other income, after offsetting capital gains.

A non-business bad debt is unrelated to a trade or business either when it was created or at the time it became worthless.   Loans to relatives are the most common non-business bad debt

In a business bad debt, the Internal Revenue Service will look at the relationship between the lender and his business or if the individual is in the business of lending money.  The use of the borrow funds does not dictate the type of the deduction.

A business bad debt deduction is allowed when it becomes partially worthless but a non-business bad debt deduction can only be deducted at time it is totally worthless.   

To substantiate the loan, the IRS will look to see if there was a properly executed note, reasonable interest rate, collateral provided, the collection effort and the intent of the parties.   This will be harder to establish, if the debtor-creditor relationship are family members (a gift may exist).

Finally, how do you prove the loan is uncollectible?  A debtor in bankruptcy or insolvent would support the lender taking a bad debt deduction.   


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