Bad Debt Deductions

To deduct bad debt, a taxpayer must have basis in the debt. This means that the debt must stem from funds the taxpayer parted with, not from something the taxpayer expected to obtain. For example, a taxpayer cannot claim a bad debt deduction for unpaid court-ordered alimony. Similarly, unpaid salaries, dividends, rental payments from investment properties, and the like are not deductible because the taxpayer does not have basis in those debts, regardless of the fact that those debts are owed.

Bona Fide Debt

A debt is bona fide if it satisfies the following four elements.

1. The obligation arises from a true debtor-creditor relationship;
2. the debtor-creditor relationship is based on a valid and enforceable obligation to pay a fixed or determinable amount of money;
3. the lender intends to seek repayment; and
4. repayment is not contingent on a future event.

Once it has been established that the debt is bona fide and the loan is delinquent, the taxpayer must demonstrate the following to qualify for a deduction.

1. At the time of the transaction, the taxpayer intended to make a loan and not a gift; and
2. the taxpayer has no reasonable expectation that the debt will be repaid.

Creditors can also deduct bad debt if the debt is bona fide and the taxpayer has no reasonable expectation of repayment. Examples include the following.

• A third-party guarantor who guarantees a loan for the benefit of the debtor. Once he pays the creditor on the debtor’s behalf, unpaid debt to the guarantor can be deductible;
• an indemnitor or surety is a creditor once the indemnitor or surety stands behind the obligor; and
• a tort victim is a creditor once the court orders the defendant to pay monetary damages to the victim.

Certain loans are vulnerable to being denied bona fide debt status. For example, the following types of loans are subject to special scrutiny when a taxpayer claims a bad debt deduction.

• Loans to family members and friends because they may be characterized as gifts; and
• loans to family corporations, which may be characterized as contributions to capital, not as a true creditor-debtor relationship.