5.33 Tax Consequences of Bad Debts
When you lend money or sell on credit and your debtor does not repay, you may deduct your loss. The type of deduction depends on whether the debt was incurred in a business or personal transaction. This distinction is important because business bad debts receive favored tax treatment.
Business bad debt.
A business bad debt is fully deductible from gross income on Schedule C if you are self-employed, or on Schedule F if your business is farming. You may deduct partially worthless business debts; see IRS Publication 535 for details.
Caution
Nonbusiness bad debt.
A nonbusiness bad debt for 2012 is reported as a short-term capital loss on Form 8949 and then entered on Schedule D. You must attach a statement that describes the debt, your efforts to collect it, and your reasons for concluding that it had become worthless. As a short-term capital loss, a nonbusiness bad debt is deductible only from capital gains, if any, and $3,000 of ordinary income ($1,500 if married filing separately). Any excess is deductible as a capital loss carryover to 2013 and later years (5.4). You may not deduct partially worthless nonbusiness bad debts. The debt must be totally worthless.
Examples of nonbusiness bad debts:
- You enter into a deal for profit that is not connected with your business; for example, debts arising from investments are nonbusiness bad debts.
- You make a personal loan to a family member or friend with a reasonable hope of recovery and you are not in the business of making loans. You must be able to show that this is a bona fide loan and not a gift. Put the loan in writing and spell out repayment terms.
- You are assigned a debt that arose in the assignor’s business. The fact that he or she could have deducted it as a business bad debt does not make it your business debt. A business debt must arise in your business.
- You pay liens filed against your property by mechanics or suppliers who have not been paid by your builder or contractor. Your payment is considered a deductible bad debt when there is no possibility of recovering reimbursement from the contractor and a judgment obtained against him or her is uncollectible.
- You lose a deposit on a house when the contractor becomes insolvent.
- You loan money to a corporation in which you are a shareholder, and your primary motivation is to protect your investment rather than your job; see below.
- You had an uninsured savings account in a financial institution that went into default. Instead of claiming the bank deposit loss as a nonbusiness bad debt, the loss may be claimed as a casualty loss, or in some cases, as an investment loss (18.5).
- You are held secondarily liable on a mortgage debt assumed but not paid by a buyer of your home. Your payment to the bank or other holder of the mortgage is deductible as a bad debt if you cannot collect it from the buyer of the home.
Filing Instruction
Guarantor or endorsement losses as bad debts.
If you guarantee a loan and must pay it off after the principal debtor defaults, your payment is deductible as a business bad debt if you had a business reason for the guarantee. For example, to protect a business relationship with a major client, you guarantee the client’s loan. Your payment on the guarantee qualifies as a business bad debt. If, as a result of your payment, you have a legal right to recover the amount from the client (right of subrogation or similar right), you may not claim a bad debt deduction unless that right is partially or totally worthless.
A loss on a guarantee may be a nonbusiness bad debt if you made the guarantee to protect an investment, such as where you are a main shareholder of a corporation and guarantee a bank loan to the company. No deduction is allowed if you guaranteed the loan as a favor to a relative or friend. Bank deposit losses are discussed in Chapter 18 (18.5).
Loans by shareholders.
It is a common practice for stockholders to make loans to their corporations or to guarantee loans made to the company by banks or other lenders. If the corporation fails and the stockholder is not repaid or has to make good on the guarantee, tax treatment of the bad debt depends on whether the stockholder is an employee who made the loan to protect his or her job. If the dominant motivation for the loan was to maintain employment, the bad debt is an employee business expense deductible only as a miscellaneous itemized deduction subject to the 2% of adjusted gross income floor (19.1). If the dominant motivation for the loan was to protect the stockholder’s investment in the company and not his or her job, the bad debt is generally a nonbusiness bad debt deductible on Form 8949/Schedule D as a short-term capital loss.
If the stockholder is in the business of lending money and the loan was made in that capacity, the bad debt would be a business bad debt, deductible on Schedule C by a sole proprietor.