If you are unable to collect a debt, the Internal Revenue Service allows you to write it off on your tax return. But before you do so, it is important to understand what qualifies as a bad debt. Like much of tax law, bad debt is not nearly as simple a concept as you might think.
To claim a bad debt on your income tax return, you must have previously claimed the amount in your income or lent it out as a cash loan. You cannot claim money expected to receive, but did not on your tax return, as that money was never part of your income to begin with. For example, if a landlord, cannot include unpaid rent as bad debt because landlord never had the rent money in possession. That rent money never made it into the bank account to be included as income, so it cannot be claimed as a bad debt. A debt becomes bad when there is no longer a reasonable expectation of repayment. To demonstrate that a debt is worthless, you must only show that you have taken reasonable steps to collect the debt.
Examples of Bad Debt
A business bad debt derives from you operating your trade or business and is generally deductible as a business loss on your income tax return. Examples of business bad debts include loans to suppliers, credits to customers and business loan guarantees. You can, however, deduct partial amounts for bad business debts.
Claiming Bad Debt
If you operate a business, then you claim your bad debt by deducting it from your gross income when figuring your taxable income. To claim the bad debt, most business owners are required to use the charge-off method. Claim business bad debt on form 1040 using Schedule C. Corporate bad debts are deducted on Form 1120.
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Considerations
You can only claim a bad debt in the year when it became worthless. If you do not deduct a bad debt on your original return for the year it becomes worthless, you can file a claim for a credit or refund due to the bad debt using Form 1040X. Allow 8 to 12 weeks for processing.
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