What Is a Bad Debt Write-Off and How to Deduct It

A bad debt write-off for taxes lets you deduct money you’re owed but will never collect, and the size of that deduction depends almost entirely on one question: was the debt tied to your business or was it personal? Business bad debts come off as ordinary deductions with no annual cap. Personal (nonbusiness) bad debts are treated as short-term capital losses, meaning they offset capital gains first and then only $3,000 of ordinary income per year, with the rest carried forward.¹ Get the classification wrong or skip the documentation and you can lose the deduction entirely.

Does Your Debt Actually Qualify

Two threshold requirements decide whether there’s anything to deduct in the first place.

The debt has to be a real one. The IRS calls it a “bona fide debt”: a legal obligation for the debtor to pay you a fixed sum. A verbal agreement can count, but a written note with terms and a repayment schedule is far harder for the IRS to dismiss.² Loans between family members and friends get extra scrutiny. If the arrangement looks like a gift dressed up as a loan — no written terms, no expectation of repayment when the money changed hands — the IRS will treat it as a gift, and gifts aren’t deductible.³

You also need basis in the debt. Basis means you either handed over cash or already reported the amount as income on a prior return. This is the trap that catches most cash-method taxpayers: if a client never paid an invoice and you never reported that invoice as income, there’s nothing to deduct. You didn’t pay tax on the money, so you can’t recover tax by writing it off.³ Accrual-method businesses land differently, because they book revenue when earned, so an unpaid invoice they already recognized as income does create basis.

Business Bad Debt or Nonbusiness Bad Debt

This is where the tax outcome is decided. Section 166 splits bad debts into two categories, and the money at stake between them is often substantial.

Business Bad Debts

A business bad debt is one created or acquired in your trade or business, or where the loss from its worthlessness happens in your trade or business.⁴ The everyday example is an unpaid customer invoice. Business bad debts are ordinary deductions that offset any income on your return — wages, business profit, investment income — with no annual dollar cap.

Business bad debts also allow partial write-offs. If a customer owes $10,000 and you conclude only $4,000 is collectible, you can deduct the $6,000 in the current year, provided you charge it off on your books. You don’t have to wait for the full debt to die.⁴

Nonbusiness Bad Debts

Everything else is a nonbusiness bad debt: personal loans, most investment-related loans, and anything else outside your trade or business. Three restrictions apply:

The debt must be totally worthless. Partial deductions aren’t allowed.⁴
The loss is treated as a short-term capital loss, no matter how long the debt was outstanding.⁴
Short-term capital losses offset capital gains first. After that, you can deduct only $3,000 per year against ordinary income ($1,500 if married filing separately), with any excess carrying forward.¹

The math tells the story. A $20,000 personal loan gone bad, with no offsetting capital gains, can take seven years or more to fully deduct. The same $20,000 as a business bad debt would reduce your taxable income by the full amount the year it went worthless.

One boundary worth naming: the nonbusiness restrictions apply to taxpayers “other than a corporation.” Corporations deduct all bad debts as ordinary losses.⁴ The business-versus-nonbusiness fight matters mainly for individuals, partnerships, and S corporation shareholders.

When It’s Not Obvious: the Primary Motive Test

Some debts don’t fit cleanly. The IRS looks at your primary motive when you made the loan. If the dominant reason was business-related — an employee lending money to keep their employer afloat and protect their job, for example — the debt is business. If the dominant motive was to earn an investment return, it’s nonbusiness.³ The taxpayer carries the burden of proving the business connection, so contemporaneous evidence of why you made the loan matters.

Proving the Debt Is Worthless

You can’t just decide the money is gone. The IRS requires reasonable collection efforts before the write-off.³ You don’t have to sue if you can show a judgment would be uncollectible anyway. Worthlessness is easier to establish when there’s a clear event: the debtor files bankruptcy, a court returns your judgment uncollectible, or the statute of limitations on collection expires.² Without one of those, build a paper trail: demand letters, notes from collection calls, records of the debtor’s financial condition, and any responses you did or didn’t get.

Timing is strict. You must deduct the debt in the tax year it became worthless. A debt that went bad in 2024 doesn’t belong on a 2026 return. If you pick the wrong year, you may need to amend — and bad debts get a longer window for that than most items (covered below).

How and Where to Report It

The form depends on the classification.

Business Bad Debts

Sole proprietors report business bad debts on Schedule C (Form 1040) as part of other business expenses.⁵ Corporations report on Form 1120, partnerships on Form 1065. Remember the basis rule: the debt must have been included in gross income for the current or a prior year to be deductible.³

Nonbusiness Bad Debts

A totally worthless nonbusiness bad debt goes on Form 8949 (Part I) as a short-term capital loss, one line per debt. In column (a), enter the debtor’s name and write “bad debt statement attached.” Enter zero in column (d) and your basis in column (e). Totals flow through to Schedule D.⁶

The attached statement is not optional. Include a description of the debt and the amount, the date it became due, the debtor’s name, any business or family relationship, what you did to try to collect, and why you concluded the debt was worthless.³ Missing this statement is one of the easiest ways to have the deduction knocked out on examination.

If You Missed the Right Year: the Seven-Year Window

Most refund claims have to be filed within three years of the original return’s due date. Bad debts get seven. Under Section 6511(d), you have seven years from the return due date for the year the debt became worthless to file a claim for refund or credit, and the extended period also covers carryovers or carrybacks affected by the deduction.⁷⁸ The longer window exists because pinning the exact year of worthlessness is genuinely hard — a debtor can string you along for years before you can say the money is truly gone.

If You Later Collect on a Debt You Already Wrote Off

Recoveries are handled under the tax benefit rule in Section 111. You include the recovered amount in gross income only to the extent the original deduction actually reduced your taxes.⁹ If the write-off didn’t lower your bill — say, because you had a net operating loss that year — the recovery isn’t taxable.¹⁰ Report the amount as income in the year you receive it, taxed at your rates that year.

1
Office of the Law Revision Counsel. 26 USC 1211 – Limitation on Capital Losses
2
eCFR. 26 CFR 1.166-1 – Bad Debts
3
Internal Revenue Service. Topic No. 453, Bad Debt Deduction
4
Office of the Law Revision Counsel. 26 USC 166 – Bad Debts
5
Internal Revenue Service. Instructions for Schedule C (Form 1040) (2025)
6
Internal Revenue Service. Publication 550 – Investment Income and Expenses
7
Office of the Law Revision Counsel. 26 USC 6511 – Limitations on Credit or Refund
8
Internal Revenue Service. Time You Can Claim a Credit or Refund
9
Office of the Law Revision Counsel. 26 USC 111 – Recovery of Tax Benefit Items
10
eCFR. 26 CFR 1.111-1 – Recovery of Certain Items Previously Deducted or Credited