Hello JA Guest,
If someone owes you money that you cannot collect, you have a bad debt.
A personal bad debt is deducted as a short term capital loss and is subject to the capital loss limitations of no more than $3,000 in total capital losses in any one tax year. If your losses exceed the amount you can deduct in the current year, you can carry forward the remaining loss to be deducted in future tax years, until you have been able to deduct the entire amount.
To be deductible, nonbusiness bad debts must be totally worthless. You cannot deduct a partly worthless nonbusiness debt.
A debt must be genuine for you to deduct a loss. A debt is genuine if it arises from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum of money.
For a bad debt, you must show that there was an intention at the time of the transaction to make a loan and not a gift. If you lend money to a relative or friend with the understanding that it may not be repaid, it is considered a gift and not a loan. You cannot take a bad debt deduction for a gift. There cannot be a bad debt unless there is a true creditor-debtor relationship between you and the person or organization that owes you the money.
You can take a bad debt deduction only in the year the debt becomes worthless. You do not have to wait until a debt is due to determine whether it is worthless. A debt becomes worthless when there is no longer any chance that the amount owed will be paid. It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. You must only show that you have taken reasonable steps to collect the debt. Bankruptcy of your debtor is considered good evidence of the worthlessness of at least a part of an unsecured debt.
Please refer to the following IRS publication under the section titled "Capital Gains and Losses - Nonbusiness Bad Debts". On page 55 under the section titled "How To Report Bad Debts" you will find specific instructions on how to report a bad debt on Schedule D.
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