Bad Debts

Lenders never loan money with the expectation they won't be repaid. They expect to collect interest during the term of the loan and recoup the amount of principal in the loan. But reality shows that some borrowers default. Taxwise, lenders may be able to write off these bad loans under certain conditions.

If you loan money to someone who fails to repay you, you can claim a loss for the outstanding balance. The conditions for writing off the loss and the manner in which the loss is treated for tax purposes depend on the type of bad debt involved. There are two types:

1. Business bad debts, which are debts arising in the course of business. For example, your business is on the accrual method of accounting and fails to receive payment on an accounts receivable; this is a business bad debt. Loans made to protect your salary are treated as business bad debts. Business bad debts are fully deductible as ordinary losses against business income.
2. Nonbusiness bad debts, which are any other type of debts. For example, you loan money to your friend to buy a car and your friend fails to repay the loan; this is a nonbusiness bad debt. Nonbusiness bad debts also include loans that you make to protect your investments and uninsured bank deposits. Nonbusiness bad debts are deductible as short-term capital losses.