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

5.34 Four Rules To Prove a Bad Debt Deduction

To determine whether you have a bad debt deduction in 2012, read the four rules explained below. Pay close attention to the fourth rule, which requires proof that the debt became worthless in the year the deduction is claimed. Your belief that your debt is bad, or the mere refusal of the debtor to pay, is not sufficient evidence. There must be an event, such as the debtor’s bankruptcy, to fix the debt as worthless.

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Planning Reminder

Debt Worthless Before Due

You do not have to wait until the debt is due in order to deduct a bad debt. Claim the deduction for the year that you can prove worthlessness occurred.

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Rule 1. You must have a valid debt.

You have no loss if your right to repayment is not fixed or depends upon some event that may not happen. Thus, advances to a corporation already insolvent are not valid debts. Nor are advances that are to be repaid only if the corporation has a profit. Voluntary payment of another’s debt is also nondeductible. If usurious interest was charged on a worthless debt, and under state law the debt was void or voidable, the debt is not deductible as a bad debt. However, where the lender was in the business of lending money, a court allowed him to deduct the unpaid amounts as business losses.

If advances are made to a company that has lost outside borrowing ...