8755 / When can a taxpayer deduct losses sustained as a result of a bad debt? What is the difference between a business bad debt and a nonbusiness bad debt?

A bad debt is a specific obligation that can be deemed with reasonable certainty to have become totally or partially worthless. If this is the case, the creditor-taxpayer may be entitled to a deduction corresponding to the amount of the worthless debt.¹

There are two kinds of bad debt deductions: (1) business bad debts and (2) nonbusiness bad debts. A business bad debt, as the name suggests, is a debt that is incurred in the conduct of the taxpayer’s trade or business. A nonbusiness bad debt is defined, by exclusion, in IRC Section 166(d)(2) as a bad debt other than a debt (a) created in the conduct of the taxpayer’s business² or (b) the loss from the worthlessness of which was incurred in the conduct of the taxpayer’s trade or business.³ The second exclusionary rule allows a taxpayer who was not the original creditor to claim a worthless debt that he acquired in the conduct of his business.

The classification as either a business or nonbusiness bad debt is important because only a business bad debt can be treated as a deduction from ordinary income, while nonbusiness bad debts receive a capital loss treatment.⁴ Further, a taxpayer can claim a deduction for wholly or partially worthless business bad debts, while nonbusiness bad debts must be completely worthless for the deduction to be allowed (see Q 8758).⁵