A bad debt is deductible for tax purposes if it is related to your trade or business. Bad debts may include accounts receivable from customers or clients that you cannot collect, and also loans or guarantees of loans that you make in the course of your trade or business. Different tax rules apply for partially and totally worthless debts.
When you have made sales or provided services on credit in your business, and you subsequently find that you are unable to collect on the account, you have a bad debt. Bad debts are business expenses and are deductible for U.S. income tax purposes.
Business Bad Debts
To be considered a bad debt and to be tax deductible, the debt must have been created or acquired in your trade or business, or it must have been closely related to your trade or business when it became partially or totally worthless. Closely related means that the primary motive for the debt was the conduct of your trade or business.
If you use the accrual method of accounting, the related account or note receivable must have been recorded on your business books when you earned the income. You cannot claim a deduction for a bad debt if the account that becomes worthless was never recorded as a receivable with the corresponding entry to income. This applies to your business as well as all other sources of taxable income. For example, if you have rental properties that do not necessarily constitute a business for you, but they generate taxable income, you can take a bad debt deduction only if you had included the rent in your income.
If you use the cash method for tax reporting, you would not have included the debt in your income, so you cannot claim it as a deductible expense when it becomes worthless.
When Is a Debt Worthless?
A debt is worthless when the facts and circumstances indicate that there is no longer any chance it will be paid. You must be able to show that you took all reasonable steps to collect the amount owed. But you do not necessarily have to wait until the debt actually becomes due if you have information indicating that it will not be paid. This does not necessarily mean the bankruptcy of the debtor, although that would be good evidence. And you do not have to take the debtor to court in order to claim a bad debt deduction.
A debt can be partially worthless. The portion that cannot be collected would qualify for a bad debt deduction, provided the total amount had been included in income. If property is received in partial payment of a debt, the amount owed is reduced by the fair market value of the property received. If that property is later sold, any gain on the sale is not considered a recovery of a bad debt. It would be reported as a gain on the sale of property, and could be ordinary income, or capital gain, depending on the circumstances. This gain would be taxable separately, regardless of whether or not any tax benefit was gained from the bad debt expense.