Bad debt accrues when someone owes you money and you don’t have a way to collect it. In order to deduct bad debt at tax time, you have to have previously included the debt amount in your income. Taxpayers are not able to deduct expected amounts that they never received, such as rent or payment for services, because the amount wouldn’t have been included in income. You must show proof that the debt was a loan and not a gift, and that you intended to receive payment in return. You are assumed to be giving a gift when there is no set understanding that the money must be repaid.

Bad debt comes in two forms: business and nonbusiness. Business bad debt evolves from business or operating expenses, and can be deducted on your income tax return. Bad business debt can include:

• Loans given to client and suppliers
• Credit sales to customers
• Business loan guarantees

These debts need to be included in your income in order to be deducted. Business debts can be deducted in part or full using either a charge-off method or the nonaccrual-experience method.

Other types of nonbusiness classify as nonbusiness. These types of bad debt have to be completely valueless in order to be deducted at tax time. Debt is considered worthless once there is no reasonable expectation of repayment based on evidence or facts. Evidence must be available to prove that you have attempted to collect the debt through appropriate action. The deduction of a bad debt must be taken the year the debt is deemed worthless, as you are not required to wait until the debt is due to claim it. If you can prove the debt is uncollectable, you don’t even have to take the matter to a court.

Nonbusiness bad debts are reported as short-term capital loss via Form 8949, Sales and Other Dispositions of Capital Assets. You have to include a detailed statement in addition to your return that explains the bad debt.