Debt Repayments & Tax Deductions

According to the Internal Revenue Service, a bad debt is a loss that results from the failure of a debtor to repay a loan. In this event, the taxpayer who made the loan can deduct the amount of the bad debt for income tax purposes. If the loan is subsequently repaid, a recovery for the bad debt must be included in the taxpayer's income in the year it is received.

Bad Debt

A debt is deemed to exist and be worthless if the taxpayer's right to repayment is fixed and an event occurs that provides sufficient evidence that the debt will not be repaid. The taxpayer's right to repayment must be established by the existence of a debtor-creditor relationship at the time of the loan. In addition, the money loaned must have been reported as income on a tax return. Finally, the taxpayer must prove that the debt became worthless during the tax year for which the he claims the deduction for the bad debt.

Tax Deduction

A lender may deduct a loss for income tax purposes in the event a debtor does not repay a personal loan. The nonbusiness debt may be claimed as a short-term capital loss using the Schedule D. In this event, the loss is deducted from any capital gains as well as $3,000 of ordinary income to be reported during the tax year. Any difference between this deduction reported in the current tax year and the total amount of the unrecoverable loan is carried over to subsequent tax years.

Recovery

According to the IRS, a return of an amount you deducted or took a credit for in an earlier year is referred to as a recovery. The payment on a bad debt that was previously reported as a deduction on a tax return is an example of a recovery.

Tax Benefit Rule

The IRS Tax Benefit Rule states that a recovery for a bad debt must be included in the taxpayer's income in the year it is received. The amount to be reported is an amount less than or equal to the amount of the deduction that was taken for the bad debt that reduced the tax in the earlier year. The amount is reported as Other Income in the return.

References

• "J.K. Lasser's Your Income Tax 2011"; J. K. Lasser Institute; 2010
• IRS.gov: Publication 525 -- Main Content