"If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours."

— John Maynard Keynes

When you make a loan and the debtor can't pay you back, you have a "bad debt." Tax law provides some relief by allowing taxpayers to take deductions for some bad debts.

The tax treatment of bad debts depends on whether the debt is a business or nonbusiness debt. Business bad debts are deductible as an ordinary business expense.

There are no limitations on the amount of the deduction. The deduction can create or increase a net operating loss.

A deduction for the partial worthlessness of a business bad debt is permitted.

What is a nonbusiness bad debt?

For example, you loan your friend some money to buy a car and he cannot pay you back. You must show that there was an intention at the time of the transaction to make a loan and not a gift. A promissory note or IOU is an example of evidence that the cash transfer was a loan, not a gift.

A nonbusiness bad debt is deductible only as a short-term capital loss, so it can only be used to offset capital gains and up to $3,000 of other income for individuals.

There is no bad debt deduction for an item not previously included in income. Bad debts from unpaid wages, fees, rents, interest and other uncollectible income do not give rise to a bad debt deduction.

No deduction is permitted for partial worthlessness. A deduction can be taken only if the nonbusiness bad debt is totally worthless.

The deduction must be taken in the proper year that the debt became worthless.

A debt is worthless when there is no reasonable hope of repayment.

In general, the taxpayer must establish that some identifiable event occurred during the course of the year that effectively establishes the time the debt became worthless.

To show that a debt became worthless during a taxable year, the taxpayer must be able to show that the debt had some vestige of value at the beginning of the year.

The mere failure of the debtor to pay on demand is not, in itself, proof of a debt's worthlessness.

The taxpayer must make reasonable efforts to collect a debt before it can be considered worthless, although courts have held that it is not necessary to sue to get a judgment against the debtor if it is clear that would serve no purpose.

A debt, also, is not worthless if the debtor may offset the debt amount which he owes to the creditor.

What to do?

For starters make a written demand for repayment. If the debtor cannot pay, ask for a statement from him or her explaining why not.

Voluntary forgiveness of a bona fide debt for reasons other than a determination that the cost of collection exceeds the value of the receivable does not entitle the taxpayer to a bad debt deduction. So if you settle for half of the debt, you can't deduct the other one-half.

A debtor's insolvency or bankruptcy are relevant factors in determining whether the debt is worthless.

However, they are not dispositive. The fact that the debtor files for bankruptcy is a good sign; but if there is a reasonable probability of some sort of partial recovery from the bankruptcy estate, then the debt is not worthless.

The fact that a bankruptcy proceeding is terminated in a particular year does not in itself mean that the bad debt loss is deductible in that year.

Some debts in bankruptcy become worthless when the bankruptcy is filed and others only when a settlement has been reached.

Similarly, the insolvency of the debtor, by itself, is also not proof that a debt is worthless. A debtor is insolvent if he or she does not have enough property (assets) to pay all of his or her debts in full as they come due, but insolvency does not necessarily mean that none of the debts will be paid at all.

Deduct nonbusiness bad debts as short-term capital losses by filing Schedule D with your Form 1040 tax return.

On line 1 of Part 1 of Schedule D, enter the bad debt amount and the name of the debtor along with the notation that a statement is attached.

The statement shows the name of the debtor and if the debtor has any family or business relationship to you, the type of debt including the amount and due date and the efforts that you have made to collect the debt.

Indicate how you decided that the debt was totally worthless.

File a claim for refund on Form 1040X if you determine that the debt actually became worthless in a prior tax year and not in the current year.

E-mail: Patti@spencerlawfirm.com