If you cannot collect a personal judgment, you may have a tax-deductible bad debt. According to the Internal Revenue Service, you may deduct the bad debt only if the amount was previously part of your income. For instance, if you made a cash loan that was not repaid, and you received a judgment against the debtor, you may deduct the judgment if you do not receive repayment. However, if the judgment received is for services you provided, you may not deduct the bad debt because it is money you never received as income.
Taking the Deduction
You may only take a deduction of bad debt that has become worthless, such as a court judgment that is uncollectible. The deduction must be taken in the year that it becomes worthless. A personal bad debt is reported on Form 8949, Sales and Other Dispositions of Capital Assets, Part 1, Line 1, as a short-term capital loss. Include the name of the debtor and attach a statement to the form explaining the bad debt. Note that a statement is attached in column (a). Enter the amount of the bad debt in column (e) and zero in column (d). Note that the deduction for a bad debt is subject to capital loss limitations rules; net capital losses are limited to $3,000, with any balance over the $3,000 carried forward to the following year.