| Nonbusiness bad debts are uncollectible obligations to you based on transactions not in the course of operating your trade or business. The most common examples of nonbusiness bad debts include debts arising from investments and personal loans.
Proving the Existence of a Bad Debt
In order to prove that you are entitled to a bad debt deduction, you must be able to first show that you have a genuine debt. If the right to repayment is not fixed or if it is contingent on the occurrence of some other event, it is not a valid debt. The Internal Revenue Service will look with particular scrutiny at loans to family members and assume that they are gifts. To overcome the gift presumption, the loan should be structured like a business transaction, with a written note setting a definite due date, interest, and required collateral. However, the failure to enforce a family debt despite the existence of a written promissory note is an indication that the transaction was indeed a gift. In addition, the voluntary payment of the debt of another person is nondeductible.
Second, you must be able to prove that a valid debtor-creditor relationship existed at the time the debt arose. The Internal Revenue Service will look for an enforceable promise to repay made at the time the transaction occurred.
Third, in order to claim a bad debt deduction, you must already have included the amount in your income. Thus, you are not entitled to a bad debt deduction for unpaid salary, rent, interest, dividends, or other similar items.
Finally, you must show that the debt became totally worthless during the tax year in which you are seeking the deduction. To prove this, you must supply evidence that the debt had value at the end of the prior year, that there was a reasonable expectation of recovery, that you tried to collect it, that some event occurred during the current tax year to make the debt uncollectible, and that the debt would have no value in the future. The taxpayer does not have to wait until the debt is due. The deduction can be claimed in the year that it becomes worthless.
Nonbusiness Bad Debt Deduction
When someone borrows money from you for nonbusiness reasons but does not repay the debt, you may be able to reduce your tax liability for the year by taking a limited deduction as a short-term capital loss. The amount of the loss is first deducted from capital gains, and the taxpayer is allowed a $3,000 deduction for the bad debt loss against ordinary income. Any excess is deductible as a capital loss carryover in future years.
The IRS permits the taxpayer to file an amended tax return for the correct year if the nonbusiness bad debt deduction is not claimed in the year that the debt becomes worthless. Copyright 2010 LexisNexis, a division of Reed Elsevier Inc. |