Ordinary Loss on a Debt Instrument: Section 166, 165, and 1244 Paths

An ordinary loss on a debt instrument is available in only three situations under federal tax law: when the debt qualifies as a business bad debt under Section 166, when a corporate parent holds worthless securities of an 80%-owned operating subsidiary under Section 165, or when debt has been converted into qualifying Section 1244 small business stock. Everywhere else, a worthless or defaulted debt produces a capital loss, and a capital loss can offset ordinary income by only $3,000 per year ($1,500 if married filing separately) beyond any capital gains you have.¹ Landing in one of the three ordinary-loss categories can mean deducting the full loss this year instead of stretching it over decades.

What Ordinary Treatment Actually Buys You

Ordinary loss offsets any type of income without limitation: wages, business profits, interest, everything. A capital loss goes through a different pipeline. You net it first against any capital gains for the year. Whatever remains is deductible against ordinary income only up to $3,000 ($1,500 for married filing separately), with the excess carried forward indefinitely.² On a six- or seven-figure loss with no offsetting gains, that difference is the difference between real tax relief and a rounding error.

Path One: Business Bad Debt Under Section 166

Section 166 is the main route to ordinary treatment for a debt you hold. It divides bad debts into two categories, and only one produces an ordinary loss.

A business bad debt is a debt created or acquired in connection with your trade or business, or one whose worthlessness was incurred in your trade or business.³ It generates an ordinary loss.

A non-business bad debt — anything else, including a personal loan or a loan motivated by investment rather than an active trade or business — always produces a short-term capital loss when it becomes worthless, no matter how long you held it.³

The Dominant-Motivation Test

For non-corporate taxpayers, the IRS looks at your dominant motivation when the loan was made. Credit extended to a customer, a supplier you depend on, or a key contractor tends to qualify as business-related. A loan to a corporation where you happen to be a shareholder usually reads as an investment, which makes it non-business. A loan to a family member almost always defaults to non-business treatment unless you can show the dominant motive was protecting your own trade or business.

Bona Fide Debt Comes First

Before the motivation question matters, the debt has to be real. The IRS requires a genuine debtor-creditor relationship based on a legally enforceable obligation to pay a fixed sum. Advances to closely held businesses with no written note, no stated interest rate, no repayment schedule, and no actual payments get recharacterized routinely — sometimes as equity contributions, sometimes as gifts, either way as non-deductible. Market-rate interest, written terms, and a paper trail of payments are what make a loan look like a loan.

Guarantee Payments Follow the Same Rule

If you guarantee someone else’s debt and pay when they default, your loss takes the character the debt would have had in your hands. A guarantee to protect an investment produces a non-business bad debt. A guarantee made to protect your own trade or business — for example, backing a loan for a supplier whose collapse would shut down your operations — can produce an ordinary loss.

Path Two: Worthless Securities Under Section 165

Debt instruments that qualify as “securities” for tax purposes are pulled out of the business bad debt rules entirely and run through Section 165 instead. A security includes any bond, debenture, note, or other evidence of indebtedness issued by a corporation or government entity in registered form or with interest coupons.⁴ Most corporate and government bonds fit the definition.

The default rule is bad news: if a security that is a capital asset becomes wholly worthless, the loss is treated as though you sold it for zero on the last day of the tax year, which makes it a capital loss.⁵ Long-term or short-term depending on holding period, but capital either way.

The Affiliated Corporation Exception

One narrow carve-out gives ordinary treatment, and it is available only to corporate taxpayers. A domestic corporation holding worthless securities of an affiliated subsidiary gets ordinary loss if both tests are met:

The parent owns stock representing at least 80% of the subsidiary’s total voting power and at least 80% of the total value of its stock.⁶
More than 90% of the subsidiary’s aggregate gross receipts across all its tax years came from active business operations rather than passive sources like royalties, rents, dividends, interest, and annuities.⁴

Individuals, partnerships, and holding companies whose subsidiaries live off passive income get nothing from this rule.

The Classification Trap

The consequence for individuals is worth spelling out. A worthless corporate bond held for a clearly business-related reason still produces a capital loss because it is a security, not a plain debt under Section 166. The form of the instrument decides the outcome. An unregistered promissory note that does not meet the security definition can qualify as a business bad debt under Section 166; a registered bond covering the same economic exposure cannot. If you have a choice about how debt is documented, this matters.

Path Three: Section 1244 Stock From Converted Debt

If you cancel a bona fide debt in exchange for stock in a qualifying small business corporation, that stock can fall under Section 1244. When Section 1244 stock later becomes worthless or is sold at a loss, an individual can treat up to $50,000 of the loss as ordinary ($100,000 on a joint return). Anything above the caps reverts to capital loss.⁷

The corporation must be a “small business corporation” — total money and property received for all its stock cannot have exceeded $1,000,000 at the time the shares were issued. It also has to be an active business: more than 50% of aggregate gross receipts over the five years before the loss must come from sources other than royalties, rents, dividends, and interest.⁷

Two traps come up often. Stock issued in exchange for other stock or securities does not qualify. And stock issued for debt that was already worthless at the time of conversion has a zero basis, which means no deductible loss regardless of characterization.

Proving Worthlessness and Timing the Deduction

Winning the characterization argument still leaves you needing to prove the debt is worthless and to claim the loss in the correct year.

Evidence of Worthlessness

A bad debt is deductible only in the tax year it becomes wholly worthless. You do not have to wait until it is due, but you do need objective evidence that no reasonable chance of repayment exists.⁸ The IRS weighs the debtor’s financial condition, any collateral, and whether legal action would realistically produce a recovery. You are not required to sue when suing would be futile.⁹ A bankruptcy filing is generally strong evidence that at least part of an unsecured debt is worthless, though the year of full worthlessness depends on any realistic prospect of a distribution.

Partial Worthlessness — Business Debts Only

Business bad debts have a real advantage: you can deduct the worthless portion of a debt without waiting for the whole balance to go bad. You must charge off the worthless portion on your books during the tax year and document the specific unrecoverable amount.¹⁰ Non-business bad debts get no partial deduction; they must be wholly worthless before anything is allowed.³

Cash-Method Taxpayers Cannot Deduct Unpaid Receivables

If you use the cash method, you cannot deduct amounts you never included in income. Unpaid invoices from a customer who stiffs you produce no deduction because the income was never reported in the first place. You can deduct a bad debt only if you previously took the amount into income or loaned out actual cash.¹¹

The Seven-Year Amended Return Window

Pinpointing the exact year of worthlessness is genuinely hard, and the code accounts for that. The usual deadline to amend a return is three years from filing, but for bad debts and worthless securities, you have seven years from the due date of the return for the year the debt became worthless.¹² If you realize in 2026 that a debt actually became worthless in 2020, you can still file Form 1040-X for 2020 and claim it.⁸

Where to Report Each Type of Loss

A business bad debt is reported as a business expense. Sole proprietors put it on Schedule C (Form 1040); corporations use their applicable business return.¹¹ No special form is needed for the ordinary loss itself.

A non-business bad debt goes on Form 8949 as a short-term capital loss and flows to Schedule D (Form 1040).¹³ Worthless securities treated as capital losses use the same forms. On Form 8949, enter the last day of the tax year as the sale date, zero as the sale price, and “Worthless” in the applicable column. Getting the characterization right on the original return is worth the effort; fixing it later means an amended return, and while the seven-year window is generous, it is still a second round of work you would rather avoid.

1
Office of the Law Revision Counsel. 26 U.S. Code 1211 – Limitation on Capital Losses
2
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
3
Office of the Law Revision Counsel. 26 U.S. Code 166 – Bad Debts
4
Office of the Law Revision Counsel. 26 U.S. Code 165 – Losses
5
eCFR. 26 CFR 1.165-5 – Worthless Securities
6
Office of the Law Revision Counsel. 26 USC Chapter 6 – Consolidated Returns
7
Office of the Law Revision Counsel. 26 U.S. Code 1244 – Losses on Small Business Stock
8
Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses
9
eCFR. 26 CFR 1.166-2 – Evidence of Worthlessness
10
eCFR. 26 CFR 1.166-3 – Partial or Total Worthlessness
11
Internal Revenue Service. Topic No. 453, Bad Debt Deduction
12
Office of the Law Revision Counsel. 26 U.S. Code 6511 – Limitations on Credit or Refund
13
Internal Revenue Service. Instructions for Form 8949