When Loans Go South: How to Handle Bad Debt on Your Tax Return

The IRS has long scrutinized individual taxpayers who claim deductions for bad debt losses. If you’re in this position, understanding the nuances could mean the difference between a valid deduction and a rejected claim.

Establishing a Bona Fide Debt

The first hurdle? Proving the money was a legitimate loan—not a gift or equity investment. That means having proper documentation, a set repayment schedule, interest charges, and evidence that repayments were expected and attempted.

Business vs. Nonbusiness Bad Debts

Once you’ve shown a valid loan existed, the next step is classification. Business bad debts offer more favorable tax treatment—they’re deductible as ordinary losses and may even be partially deductible. In contrast, nonbusiness bad debts are treated as short-term capital losses, capped at $3,000 annually for most taxpayers. Worse, partially worthless nonbusiness debts can’t be deducted at all.

Special Cases: Loans to Employers

Loans to your employer fall under unreimbursed employee business expenses, which were disallowed by the Tax Cuts and Jobs Act through 2025. That means no deduction for now—though that could change if Congress acts.

10 Factors That Help Prove It’s a Loan

From having a formal agreement and maturity date to charging interest and avoiding shareholder overlap, these ten criteria from a federal court case help prove a loan’s legitimacy.

Business Motivation Is Key

To classify a loan as a business bad debt, there must be a “dominant business motivation.” Helping a critical vendor survive? That may qualify. Loaning to a friend who owns a business? Probably not.

Need help classifying a debt or filing an amended return? Verity CPAs can guide you through the 

documentation and deduction process. Contact us today at info@verity.cpa or 808.546.5026 to make sure your write-off holds up to IRS scrutiny.