Bad Debt Deduction
There are two kinds on bad debt deduction. One is a business bad debt deduction and the other is the non-business bad debt deduction. They have some things in common, however.
A bad debt is money that is owed to you that can not be collected. When you operate a business, this is income that should be realized but because of the failure of the debtor to pay, it never is collected. For tax purposes, this debt must be one that is incurred in the normal course of business or trade. In may be claimed in part or in full as a normal business expense that reduces gross income. This is called a business bad debt.
A non-business bad debt operates slightly differently. Since it is not something that takes place in the normal operation of a business, it must represent income that has all ready been received and then is loaned to a person who fails to repay it. It can not be income that is expected, but never received. To explain this difference, consider this example: a home improvement company performs some repairs on a home and presents a bill for their services. The homeowner does not pay and eventually files for bankruptcy.
The home repair company is unable to recover any of its debt in the bankruptcy settlement. The company never received any income from this transaction, but the amount that was billed and never received is a bad debt and can be deducted from gross income for profit and taxation purposes. This is true even if the only actual loss to the company was the time and efforts of their employees since repairing of homes is their normal business operation.
For an individual, however, they must have received some income and then made a loan that is totally uncollectible. It is not necessary that the taxpayer go to court and attempt to recover the debt if they can show that it would have been uncollectible even with a court judgment. They also must be able to prove that the transaction was always intended to be a loan and not a gift. This usually means that some sort of documentation is very important in such a transaction. A promissory note of some type would be a good way to establish that this was intended as a loan.
The taxpayer claims this non-business bad debt on Form 1040 Schedule D as a short term capital loss. It is very important that the taxpayer understands the difference between the business and non-business bad debt deduction. If an individual who was not operating a recognized business did the above home repair and never received expected payment, this loss of his time and energy and the money he was promised, but never paid, would not be deductible as a bad debt.