Key Takeaways
- Must have "basis" in debt (previously included in income or loaned cash).
- Cash basis: cannot deduct unpaid receivables (no basis).
- Accrual basis: can deduct A/R gone bad.
- Business bad debt = ordinary loss (fully deductible).
- Non-business bad debt = short-term capital loss ($3,000 limit).
- Specific charge-off method required (no reserves).
Last updated: January 2026
Business Bad Debts
Why This Matters for the Exam
Bad debt rules test accounting method knowledge. Know the basis requirement and business vs. non-business distinction.
Expect at least 2-3 questions on bad debts.
The Basis Requirement
| Accounting Method | Bad Debt Deduction? |
|---|---|
| Cash basis | NO (never included in income) |
| Accrual basis | YES (already in income as A/R) |
| Loaned cash | YES (have basis in loan) |
Cash Basis Trap
| Scenario | Deduction |
|---|---|
| Plumber bills $500, client doesn't pay | $0 |
| Reason: Never included in income | No basis to deduct |
Accrual Basis
| Scenario | Deduction |
|---|---|
| Accrual business has $500 A/R | |
| Client goes bankrupt | |
| Result: $500 bad debt deduction | Reverses income already reported |
Business vs. Non-Business Bad Debts
| Feature | Business | Non-Business |
|---|---|---|
| Origin | Trade or business | Personal loan |
| Loss type | Ordinary loss | ST capital loss |
| Deduction limit | None | $3,000/year |
| Partial worthlessness | Deductible | NOT deductible |
Specific Charge-Off Method
| Rule | Description |
|---|---|
| Required | For most taxpayers |
| No reserves | Cannot use "allowance for doubtful accounts" |
| Specific debt | Must identify the worthless debt |
Bona Fide Loan Requirement
| For Non-Business | Required |
|---|---|
| Written agreement | Recommended |
| Interest rate | Recommended |
| Repayment schedule | Recommended |
| Without these | May be reclassified as gift |
Tax Benefit Rule (Recovery)
| Rule | Effect |
|---|---|
| Deducted bad debt in Year 1 | |
| Client pays in Year 3 | |
| Include in Year 3 income | To extent deduction reduced tax |
Real-World Scenario
Scenario: Investor lends $50,000 to friend's startup. Not in lending business. Startup fails completely two years later.
- Classification: Non-business bad debt.
- Loss type: Short-term capital loss.
- Annual deduction: $3,000 (after offsetting gains).
- Years to fully deduct: Up to 17 years.
Business Bad Debt Example
| Item | Amount |
|---|---|
| Accrual-basis A/R | $10,000 |
| Customer files Ch. 7 bankruptcy | |
| Expected recovery | 20% ($2,000) |
| Partial worthlessness | $8,000 deductible |
| Loss type | Ordinary (fully offsets income) |
On the Exam
Expect 2-3 questions on bad debts, typically:
- Basis Questions: "Can cash-basis taxpayer deduct unpaid invoice?"
- Classification Questions: "Is this business or non-business bad debt?"
- Partial Worthlessness: "How much can be deducted for partial worthlessness?"
The key is to remember: Must have basis. Cash basis = no deduction for unpaid invoices. Business = ordinary loss. Non-business = ST capital loss ($3,000 limit). Use specific charge-off.
Test Your Knowledge
Accrual-basis taxpayer has $1,000 A/R from bankrupt customer. Expected 20% recovery. Deductible bad debt?
A
B
C
D
Test Your Knowledge
Personal loan to friend ($50,000) becomes worthless. Classification?
A
B
C
D
Test Your Knowledge
Cash-basis plumber has $500 unpaid invoice. Bad debt deduction?
A
B
C
D