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The Online Advisor - March 1999
If you can't collect, maybe you can deduct
Bad debts are tax-deductible in the year they become worthless.
Business vs. nonbusiness
A business bad debt is a loss resulting from the worthlessness of a debt that arose from operating a trade or business,
or from a debt with a business motive. Examples include losses resulting from credit sales or services to customers
and from loans to clients, distributors, and suppliers. A fully or partially worthless business debt is deductible
from gross income.
Other bad debts are called nonbusiness bad debts. Examples include losses resulting from personal investments, secondary liability on a mortgage debt, or loans to family members, friends, or a corporation in which the creditor is a shareholder. Such debts must be fully worthless to be deductible, and then they are deductible only as short-term capital losses. The deduction should be accompanied by a description of the debt, name of debtor, efforts made to collect, and an explanation of why the debt is considered worthless.
Whether a loan you make is business-related or not, be sure to document that the debt exists. If the debt turns out to be uncollectible, keep records of your efforts to collect. Otherwise, the IRS may disallow your bad debt deduction.