Tax ramifications can be good or bad

financial distress debt in business

Few things are as upsetting as not getting paid what you are due. However, if the debt isn’t paid, you could claim a tax deduction to compensate for some of the lost money. The IRS divides bad debt into business and non-business categories, each with different standards for deductibility.

Business bad debt

According to the IRS, a debt must have a close relation to your trade or business to qualify as a deductible business bad debt. Both of the following are requirements for a valid deduction:

  • The sum is currently or has been income or an asset
  • The debt is either partially or entirely worthless

There are several ways to assess if a debt is worthless, but you should be able to provide a summary of your collection efforts at least. Then, if those claims are accurate and you decide that the debt is, in fact, bad debt, you can write it off as a business expense.

Non-business bad debt

All bad debt that cannot be recognized as being tied to business is categorized as non-business. A non-business bad debt deduction requires that the debt be completely worthless. Therefore, there is no option for a partial deduction. Additionally, you must demonstrate that the debt is a loan with a repayment plan rather than a gift, particularly if it was for a friend or member of your family. A signed contract is the most significant evidence of this.

You can record the sum as a short-term capital loss if you decide the bad debt is legitimate. The loss is subject to capital loss limitations, and you must provide the following statement with your tax return:

  • Description of the debt
  • Amount of the debt and when it became due
  • Name of the debtor
  • Business or family relationship between you and the debtor
  • Efforts you made to collect the debt
  • Why you decided the debt was worthless

The other side of the coin

The tax code typically requires you to report the forgiven debt as income on your tax return if you owe someone money and they write off the loan. There are circumstances, though, in which it is not necessary. If you have forgiven debt this year, you should request a reassessment of your tax situation. This is particularly relevant if the discharged debt is one of the following:

  • A home mortgage
  • Student loans (especially for failed schools)
  • Pandemic-related debt forgiveness

While no one wants to be able to eliminate debt, it is comforting to know that you can at least receive a tax break. Contact our RRBB accountants and advisors to establish a course of action if you find yourself in this scenario or intend to borrow money in the future.


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