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.
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.
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.
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.