By Alan S. Kufeld, CPA, Partner
Key Takeaways
- A non-business bad debt must be a bona fide, legally enforceable loan to qualify for a tax deduction.
Documentation such as a signed agreement or promissory note is critical to prove the loan was not a gift. - Only wholly worthless debts are deductible as short-term capital losses.
The IRS requires evidence like failed collection efforts or debtor insolvency to support the claim. - Non-business bad debt deductions are limited and must be claimed in the year the debt becomes uncollectible.
Individual taxpayers can use these losses only against capital gains or up to $3,000 of ordinary income per year.
It’s not uncommon for individuals to lend funds to friends or family members with the expectation of repayment, only to find themselves unable to recover the funds that were originally loaned. When personal loans become uncollectible, taxpayers may be eligible to claim a non-business bad debt deduction — subject, of course, to specific Internal Revenue Service (IRS) requirements.
Defining Non-Business Bad Debt
A non-business bad debt arises when a bona fide loan — originating outside the scope of a trade or business — becomes entirely worthless. Unlike business-related debts, which may be deducted as ordinary losses, in general non-business bad debts are treated as short-term capital losses under Internal Revenue Code (IRC) Section 166(d). Guidance on whether a taxpayer is in the trade or business of loaning money is beyond the scope of this article, but suffice to say that an occasional loan by an individual would not put them into the business of loaning money.
Here’s What You Need to Know
To qualify as a non-business bad debt eligible for a tax deduction, the debt must meet the following criteria:
1. Legally Enforceable ObligationThe taxpayer must demonstrate that the transaction was in fact a genuine debt and not a gift. This generally requires a written agreement, promissory note or other documentation establishing the terms of repayment. In the absence of formal documentation, the IRS may recharacterize the transfer as a non-deductible gift.
2. Debt Must Be Wholly Worthless
The debt must be entirely uncollectible in the year the deduction is claimed. Worthlessness is determined based on facts and circumstances — such as the debtor’s insolvency, bankruptcy or failed, written collection efforts. Partial losses do not qualify for a deduction.
3. Substantiation Requirements
Taxpayers must retain adequate documentation, including, but not limited to:
- A copy of the original loan agreement.
- Evidence of the amount loaned and date of transfer.
- The name and relationship of the debtor.
- Records of reasonable collection efforts (e.g., correspondence, demand letters).
- Proof of insolvency, bankruptcy or other factors supporting worthlessness.
PKF O’Connor Davies Observation: Non-business bad debts are treated as short-term capital losses, regardless of how long the debt was outstanding. This makes the losses subject to the capital loss limitation rules, which are restrictive – the loss can generally only be used against other capital gains, with strict limits on how much can be used against ordinary income per year ($3,000 per year for those taxpayers filing jointly).
Importantly, a non-business bad debt deduction is only allowable in the year the debt becomes totally worthless. If a taxpayer determines after their tax filing that a debt was in fact uncollectible in a prior year, an amended return (Form 1040-X) should be filed to claim that loss.
What Is the Tax Impact If the Debt Is Later Repaid?
Generally, if a previously written-off bad debt is later repaid, the recovered amount may be subject to tax. Only the portion that resulted in a prior tax benefit, however, must be included in taxable income.
Final Considerations
Claiming a deduction for a non-business bad debt involves thorough evaluation, accurate documentation and prompt action. We advise clients to keep written loan agreements on file and to record all collection efforts as they occur. If you believe a loan may no longer be collectible or need help determining whether a deduction is available, our team is ready to offer guidance specific to your circumstances.
Contact Us
Our professionals are available to assist you with tailored guidance. For specific inquiries regarding the above, please reach out to your PKF O’Connor Davies service team or:
Alan S. Kufeld, CPA
Partner
akufeld@pkfod.com | 646.449.6319