In the past couple of years, bad debts and theft losses have become almost commonplace. Years ago we rarely ever saw a bad debt or theft loss on a tax return. But today, between the economy, fraudulent investments, and failing businesses, these debts are everywhere.
To understand how to deduct these bad debts you need to understand the differences between debts that can happen on an individual tax return and those that can happen on a business tax return. Let's look at individual first.
Most bad debts that occur with an individual's finances will end as a capital loss, which is limited to $3000 a year or to only go against passive gains. For example, if you invest or loan money to a business, buy stock in a business, or put money into a failed investment, all of these are considered capital losses and fall under the $3000 a year limitation. The only way to deduct more than $3000 a year, other than having passive gains, is to prove the bad debt happened because of theft, fraud, or casualty losses. In order to prove this one of the following things must happen:
The person or business you loaned or invested money has to have been indicted by the SEC, FBI, or other federal or state agencies.The principles involved in the business or investment have been arrested and put in jail.An unforeseen natural disaster is the cause of the loss.A business is a little easier to prove and write off. If your business loans money or invests money and the money is lost because of any of the above mentioned circumstances, it can be used to claim the bad debt. But in addition to the reasons listed above, the business can deduct a bad debt if the business makes an attempt to collect and the attempt fails. There has to be some sort of documented attempt. A few phone calls will not be sufficient. The best way is to hire an attorney to attempt collection. You don't have to spend thousands of dollars or spend years trying to collect. Make a reasonable attempt, and as soon as it is obvious you can no longer collect the money, the business can write off the bad debt.
One additional thing to keep in mind is that in order to deduct this type of debt on your taxes, you need to have documentation that there was an exchange of money such as a cleared check, wire transfer documentation, etc. There also needs to be an agreement as to compensation, such as a note or business agreement.
Claiming this type of loss on your taxes is a delicate and thorough process. Knowing that the individual or company is having a rough time and being pretty sure you won't get your money back is not enough. You need to be able to prove to the IRS, if necessary, that you did everything in your power to get reimbursed. Then, in the year you determine it a lost cause, you can claim the bad debt.
For more information on bad debts and to learn more about other tax deductions you may qualify for, visit http://avoidbeingaudited.com/.
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