IRS Bad Debt Guidelines: How to Handle Unpaid Debts on Taxes

Understanding When IRS Bad Debt Guidelines Allow Deductions

IRS bad debt guidelines provide a clear framework for determining when you can write off unpaid debts on your tax return. If you’ve loaned money, sold goods, or offered services that were never paid for, the IRS allows certain bad debts to be deducted—if they meet specific conditions.

What Qualifies as a Bad Debt Under IRS Guidelines

To claim a bad debt deduction, the debt must be real and previously included in your taxable income or be a loan you expected to be repaid.

Types of Debt That May Be Deductible

• Business-related debt like unpaid invoices from customers
• Loans made in the course of business, such as lending to suppliers or clients
• Documented personal loans with clear terms and intent to repay

Non-qualifying Situations

• Gifts, even if you expected repayment
• Verbal agreements without supporting documents
• Loans that were never enforceable under state law

In short, the IRS only recognizes debts that were legitimate, enforceable, and have become worthless.

Unsure if your debt qualifies? Get a free tax case review to speak with a professional.

Business vs. Non-Business Bad Debt

The IRS treats bad debt differently depending on whether it was connected to your business.

Key Differences

• Business bad debt is fully deductible from ordinary income.
• Non-business bad debt is considered a short-term capital loss and is subject to limits on how much you can deduct per year.

Examples

• Business: A construction company is never paid for a completed job.
• Non-business: You loaned money to a friend who never paid you back.

Knowing the difference is crucial. Misclassification can lead to audit risk or IRS penalties.

For business owners, explore additional strategies on tax debt relief for unpaid obligations.

When Is a Debt Considered Worthless?

You can’t deduct a bad debt just because it hasn’t been paid. According to IRS bad debt guidelines, you must prove that the debt is truly uncollectible.

Evidence Required

The IRS expects documentation showing that the debt has no chance of being repaid. This might include:

• Multiple unsuccessful attempts to collect
• Letters sent to the debtor
• Bankruptcy filings
• Legal judgments that weren’t enforced

Factors Considered

Timing also matters. If a debtor is simply late, the debt may not yet be “worthless.” The IRS looks at when you reasonably determined it couldn’t be recovered.

How to Report Bad Debt on Your Tax Return

Once you’ve determined a debt qualifies, the next step is reporting it correctly to the IRS.

Forms Used

• Business bad debts: Report on Schedule C (sole proprietorship) or business return
• Non-business bad debts: Use Form 8949 and report the loss as a short-term capital loss

Recordkeeping

Always keep supporting documentation:

• Original loan or credit agreement
• Payment history
• Correspondence or legal actions taken
• Any proof that the debtor could not or would not pay

This evidence is key in the event of an audit.

Common Mistakes in Applying IRS Bad Debt Guidelines

Mislabeling Personal Loans as Business

You can’t claim a personal loan as a business loss unless it was directly tied to business activity. Mislabeling can lead to penalties and interest.

Lack of Written Evidence

Without written documentation, such as contracts, invoices, or email confirmations, your deduction may be denied during an audit.

Avoid costly errors. Review your deductions with a licensed tax professional before filing.

Applying IRS Bad Debt Guidelines to Your Tax Strategy

Using IRS bad debt guidelines effectively can help reduce your tax burden while staying compliant. Whether you’re a small business owner or someone who has made a personal loan, understanding these rules ensures you make informed decisions about deductions.

A small amount of effort upfront, like writing a formal loan agreement and tracking communications, can make a big difference later if the debt goes unpaid.

Deduct the Right Way Using IRS Bad Debt Guidelines

Don’t leave money on the table. If you’re dealing with unpaid debts that meet IRS bad debt guidelines, you may be able to legally reduce your tax liability. If you’re unsure where to start, let a professional walk you through the process from documentation to deduction.

Contact us to connect with trusted tax advisors who can help you deduct bad debts the right way—and avoid common pitfalls along the way.

Frequently Asked Questions (FAQs)