J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

5.33 Tax Consequences of Bad Debts

When you lend money or sell on credit and your debtor does not repay, you may deduct your loss. The type of deduction depends on whether the debt was incurred in a business or personal transaction. This distinction is important because business bad debts receive favored tax treatment.

Business bad debt.

A business bad debt is fully deductible from gross income on Schedule C if you are self-employed, or on Schedule F if your business is farming. You may deduct partially worthless business debts; see IRS Publication 535 for details.

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Caution

Accounts and Notes Receivable

You may claim a bad debt deduction for accounts and notes receivable on unpaid goods or services only if you have included the amount due as gross income. Thus, if a client or customer fails to pay a bill for services rendered, you do not have a deductible bad debt where you have not reported the amount as income (40.6).

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Nonbusiness bad debt.

A nonbusiness bad debt for 2012 is reported as a short-term capital loss on Form 8949 and then entered on Schedule D. You must attach a statement that describes the debt, your efforts to collect it, and your reasons for concluding that it had become worthless. As a short-term capital loss, a nonbusiness bad debt is deductible only from capital gains, if any, and $3,000 of ordinary income ($1,500 ...