Tax Deduction for Bad Debt: What You Need to Know

Tax Deduction for Bad Debt and How It Works

Tax deduction for bad debt is a valuable tax break for individuals and businesses who suffer financial losses from unpaid loans or receivables. If someone owes you money and you’ve exhausted all options to collect it, the IRS may allow you to claim that loss as a deduction on your tax return.

What Counts as Bad Debt Under IRS Rules

To claim a deduction, you must first determine if the debt qualifies under IRS rules.

Business vs. Non-Business Bad Debt

Business bad debt typically comes from loans or credit extended in the course of operating a business. For example, a supplier might deduct an unpaid invoice. Non-business bad debt involves personal loans or funds lent outside of a business context, such as lending money to a friend or family member.

Examples of Deductible Bad Debt

You may be eligible to deduct debts such as:

• A customer’s unpaid invoice
• A written loan agreement that remains unpaid
• A deposit for services never rendered
• A vendor advance that’s never refunded

For tax planning advice around business deductions, see our tax debt relief resource page.

When You Can Claim a Bad Debt Deduction

Timing is critical when deducting bad debt.

Requirements for Deductibility

To claim a tax deduction for bad debt, the debt must be:

• Legitimate (not a gift)
• Previously included in your income or given with the expectation of repayment
• Totally worthless—not just partially unpaid

Timing the Deduction

You must claim the deduction in the tax year the debt becomes worthless. This usually requires demonstrating that you’ve taken reasonable steps to collect it and that there’s no chance of recovery.

How to Document a Bad Debt for the IRS

Good documentation strengthens your case if the IRS reviews your deduction.

Proving the Debt Exists

Collect and retain:

• Invoices
• Promissory notes
• Loan agreements
• Email or written records of repayment terms

Need help organizing documentation? Learn how legal professionals assist with IRS documentation.

Efforts to Collect

Before claiming a deduction, you should make genuine attempts to recover the debt. This could include sending written reminders, hiring a collection agency, or pursuing legal action. Keep copies of all communication and documentation.

How to Report Bad Debt on Your Tax Return

Filing requirements depend on whether the debt is business-related or personal.

IRS Forms and Filing Tips

For non-business bad debt, report it on Form 8949 and Schedule D as a short-term capital loss—even if the debt was outstanding for more than a year.

Reporting for Businesses

Businesses typically report bad debts on Schedule C (for sole proprietors) or on the appropriate line of their corporate tax return. The amount is deducted as an ordinary business expense.

Risks and Red Flags to Avoid

Missteps in this process can lead to IRS scrutiny or denial of your deduction.

Common IRS Mistakes

You can’t claim a tax deduction for bad debt if the money was a gift, lacked documentation, or was never expected to be repaid. Informal loans without written agreements are harder to prove.

Audit Triggers

Claiming large or frequent bad debt deductions—especially without strong evidence—may increase your chances of being audited. Keep detailed records and be prepared to justify your claim.

Know When to Deduct a Bad Debt Correctly

A tax deduction for bad debt can help offset financial losses, but you must follow IRS rules carefully. If the debt meets the criteria for worthlessness, and you have documentation to back it up, you may be able to reduce your taxable income for the year.

Get Help Claiming a Tax Deduction for Bad Debt

Not sure how to claim a tax deduction for bad debt? A licensed tax professional can walk you through the process. They’ll help you gather documentation, determine the correct timing, and file the right forms to ensure you’re claiming the deduction properly and legally.

Frequently Asked Questions (FAQs)