The debate rages on about whether we are already in a recession or will soon be in one.

In this environment, bad debt losses become more likely.

For individual taxpayers, the issue of deducting bad debt losses has been a source of controversy with the IRS for ages.

Read this article for a refresher on the issue along with a potential strategy to get better tax results in one commonly encountered scenario. Here goes.

Bad Debt Deduction Basics

To claim a deductible bad debt loss, you as an individual taxpayer must first be prepared to prove that the loss was from a bona fide loan transaction that went sour instead of from some other ill-advised move such as

a contribution to the capital of a business entity that turned out to be a loser, or

an informal advance to a friend or relative that you hoped and trusted would be paid back, but that turned out to be an unintended gift.

Assuming you can establish there was a bona fide debt that has now become worthless, the next issue is whether it was a business bad debt or a non-business bad debt. Tax-wise, this is an important distinction.

Business Bad Debt Losses Receive Favorable Tax Treatment

For federal income tax purposes, business bad debts are treated as ordinary losses that you can usually deduct without any limitations. In addition, you can claim partial worthlessness deductions for business debts that go partially bad.1

Key point. Business taxpayers, such as corporations and LLCs, face an easier path to deducting bad debt losses. But we are going to focus on individual taxpayers here, to keep this from turning into a whole book. You’re welcome!

Non-Business Bad Debt Losses Receive Not-So-Great Tax Treatment

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