Did you loan money to someone who isn't paying you back? While you may never see that money again, you can still use it to reduce your tax bill next spring. How? Here are two methods, depending on the reason for the loan.

Business Debts

If you loaned the money in the course of business, you may take a deduction for a business bad debt. The loan must have been for a bona fide business reason (as opposed to an investment), such as loans to keep a vendor or partner afloat or credit extended to customers who then fail to pay.

Once the loan becomes noncollectable, a company that uses accrual accounting may generally deduct the debt to reduce its taxable income. If the money is ever collected in the future, the same taxpayer or business would include that amount in taxable income. 

Non-Business Debts

Aside from unpaid accounts receivable, personal loans are the most common type of bad debt. And many individuals aren't aware how these can be used in their tax forms. Once you determine that the debt has become worthless — meaning you won't get any additional money in payment — you may usually deduct that debt as a capital loss on your personal Form 1040. 

Capital losses first offset any capital gains from other investments. Then, the taxpayer may use any additional losses against up to $3,000 of his or her gross income each year. The unused portion carries forward to future years until it's all gone. 

Remember that you must be able to show that the loan was an actual loan for which you expected to receive repayment. A written agreement is ideal, but any documentation that shows an agreement to repay the money with interest would likely be acceptable.

Then, you must also be able to prove that it's reasonable to deem it noncollectable. This may be done with printed emails or text conversations as well as witnesses' statements or your own detailed notes. You may need to provide this documentation to the IRS, so gather your evidence when preparing your taxes.

Do you want to use the bad debt deduction in order to lower your personal or business taxes? While this is an imperfect solution to the lost money, it does recoup at least some of your investment. And it may continue to help your tax bill for several years to come. To learn more about claiming your rightful deduction, work with a tax preparation service like Jeffrey Beebe CPA soon as possible. 

Share