Are Written-Off Loans Tax Deductible as Bad Debts?

Yes, written-off loans can be tax deductible as bad debts, but only if the loan was a genuine debt with an expectation of repayment, the borrower truly cannot pay, and you claim it in the correct year. The size of the deduction depends entirely on whether the loan was tied to your business or was personal. A business bad debt is an ordinary loss that offsets any kind of income at your marginal rate. A personal bad debt is treated as a short-term capital loss, which first offsets capital gains and then only $3,000 of ordinary income per year, with the rest carried forward.¹

The Loan Has to Be a Real Debt First

Before any deduction is possible, the IRS requires the loan to be a “bona fide debt”: a real creditor-debtor relationship based on an enforceable obligation to repay a fixed sum.² In practice, that means a written promissory note stating the amount, the interest rate, and a repayment schedule. Without documentation, the IRS can recharacterize the transfer as a gift, and gifts are never deductible.

This matters most when the borrower is a friend or family member. The IRS says outright that if you lend money to a relative or friend “with the understanding the relative or friend may not repay it,” you have to treat it as a gift.³ Loans inside a family get extra scrutiny, so the arrangement needs to look like a business transaction from day one: charge at least the IRS’s Applicable Federal Rate, set a fixed repayment schedule, and actually follow up when payments are missed.

Business Bad Debt vs. Nonbusiness Bad Debt

The classification is what drives the tax result, so it’s worth getting right.

Business Bad Debts

A business bad debt comes from a loan created or acquired in your trade or business, or closely tied to it. The test is whether your dominant motivation for making the loan was business-related.³ Unpaid customer invoices, advances to a struggling supplier, and loans to employees connected to business operations are typical examples.

These are ordinary losses. They offset any taxable income at your marginal rate, which in 2026 runs from 10% to 37%. You can also deduct a business bad debt that is only partially worthless, so a deteriorating receivable does not have to be a complete loss before you claim part of it.

One condition often trips up cash-method taxpayers: you can deduct a business bad debt only if the amount was previously included in your gross income.³ Accrual-method businesses record revenue when it’s earned, so they clear this hurdle automatically. Cash-method businesses that never booked the receivable as income have nothing to deduct because they never reported the income. If instead you lent actual cash from the business, the deduction is available regardless of accounting method.

Nonbusiness Bad Debts

Any bad debt that doesn’t come out of your trade or business is a nonbusiness bad debt.⁴ Personal loans to friends and relatives make up most of these. Two restrictions apply that don’t apply to business debts.

First, the debt must be totally worthless. Partial worthlessness does not qualify.³ If the borrower is still making occasional payments, the IRS considers the debt not yet worthless, and you have to wait.

Second, the loss is a short-term capital loss no matter how long you held the note.⁵ It offsets your capital gains for the year first. Anything left over is deductible against ordinary income only up to $3,000 per year ($1,500 if married filing separately).¹ The rest carries forward year after year until it’s used up.⁶ A $15,000 personal loan that goes bad could take five years to fully deduct if you have no capital gains to soak it up.

Proving the Debt Is Worthless

Most bad debt claims fall apart on this point. The IRS wants facts and circumstances showing there’s no reasonable expectation of repayment, and that you took reasonable steps to collect.³ A lawsuit isn’t required. The IRS acknowledges that going to court is pointless if any judgment would be uncollectible. But you do need evidence you tried.

Strong evidence includes:

A borrower’s bankruptcy filing, especially a discharge with no remaining assets.
Documentation that the borrower’s liabilities far exceed their assets.
Demand letters, follow-up emails, or a collections agency report showing the debt is uncollectible.
Records of unsuccessful attempts to locate a borrower who has disappeared.

Timing is just as important as evidence. The deduction has to be taken in the year the debt actually became worthless. Claim it too early and it gets disallowed for lack of proof. Claim it too late and you’ll need to amend. When a debt deteriorates gradually, pinning down the exact year is a judgment call, and the IRS challenges it often.

How to Report It on Your Return

Personal Loans

Report a totally worthless nonbusiness bad debt as a short-term capital loss on Form 8949, Part I, line 1, with box C checked. In column (a), enter the debtor’s name and the words “bad debt statement attached.” Put zero in column (d) as proceeds and your basis (usually the cash you loaned) in column (e). The totals move to Schedule D of Form 1040.⁷

You also have to attach a separate statement describing the debt (amount and date due), identifying the debtor and your relationship, listing your collection efforts, and explaining why you concluded the debt is worthless.⁷ Leaving the statement off is one of the fastest ways to lose the deduction.

Business Loans

Sole proprietors deduct business bad debts on Schedule C (Form 1040). Partnerships and other business entities use their own applicable returns.³ A separate statement isn’t technically required, but you’ll want documentation showing the business purpose of the loan, the amount included in income, and the evidence of worthlessness in case the IRS pushes back.

If You Missed the Year, You Have Seven

Most refund claims are locked in after three years. Bad debts get a longer window. If you should have claimed the deduction in an earlier year or need to amend, you have seven years from the due date of the return for the year the debt became worthless.⁸ File Form 1040-X for the correct year. The IRS also suggests keeping your bad debt records for at least seven years to match this extended period.⁹

Loans You Guaranteed for Someone Else

If you co-signed or guaranteed a loan and paid because the borrower defaulted, that payment can be a bad debt. Extra rules apply. Under Treasury Regulations, the guarantee had to be entered into in the course of your trade or business or in a transaction for profit, you must have had a legal obligation to pay, and the agreement had to exist before the debt became worthless. Guarantees for a spouse or dependent-family-member borrower require direct consideration (actual cash or property you received for the guarantee), not just an indirect business benefit.¹⁰ And if you still have a right to collect from the original borrower, you cannot claim the loss until that right itself becomes worthless.

What Happens If the Borrower Later Pays

If some or all of a written-off debt gets repaid after you took the deduction, you have to report the recovered amount as income in the year you receive it. Under Section 111, you include the recovery only to the extent the original deduction actually reduced your tax.¹¹ If the deduction gave you no tax benefit (say, you had no taxable income that year), the recovery isn’t taxable.

Mistakes That Get the Deduction Disallowed

The accuracy-related penalty for a misreported deduction is 20% of the underpayment, so the details matter.¹² A few problems come up over and over:

No written loan agreement. Undocumented transfers to family look like gifts, and a promissory note created after the fact reads like one.
Claiming the deduction too early. You need proof the borrower cannot pay, not a hunch that they won’t.
Claiming a partial loss on a personal loan. Only business bad debts can be partially deducted; personal loans are all or nothing.
Using the wrong year. If the debt became worthless in 2024 and you claim it on your 2026 return, the IRS can deny it. The seven-year window fixes this only if you amend the correct year.
Forgetting the bad debt statement. For personal loans, the written explanation attached to the return is mandatory.

1
Office of the Law Revision Counsel. 26 USC 1211 – Limitation on Capital Losses
2
eCFR. 26 CFR 1.166-1 – Bad Debts
3
Internal Revenue Service. Topic No. 453, Bad Debt Deduction
4
Office of the Law Revision Counsel. 26 USC 166 – Bad Debts
5
Office of the Law Revision Counsel. 26 USC 166 – Bad Debts
6
Office of the Law Revision Counsel. 26 USC 1212 – Capital Loss Carrybacks and Carryovers
7
Internal Revenue Service. Publication 550, Investment Income and Expenses
8
Office of the Law Revision Counsel. 26 USC 6511 – Limitations on Credit or Refund
9
Internal Revenue Service. How Long Should I Keep Records
10
eCFR. 26 CFR 1.166-9 – Losses of Guarantors, Endorsers, and Indemnitors
11
Office of the Law Revision Counsel. 26 USC 111 – Recovery of Tax Benefit Items
12
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments