8756 / When is a taxpayer entitled to claim a bad debt deduction?

A taxpayer may claim a bad debt deduction (whether it is a business bad debt or a nonbusiness bad debt, see Q 8755) for debt owed when the debt is a bona fide debt that has become worthless.1

A “bona fide debt” is one that arises from a debtor-creditor relationship involving a valid and enforceable agreement to pay a specific sum of money.² An agreement is considered to be a valid and enforceable agreement if it includes an unconditional promise by a debtor to pay the creditor.³

A taxpayer’s voluntary undertaking to pay another debtor’s obligations does not give rise to a valid and enforceable agreement for this purpose. Despite this, if the taxpayer volunteers to pay another person’s obligation for a business purpose, and that debt subsequently becomes worthless, the taxpayer may be entitled to deduct the amount of the loss as a business expense under IRC Section 162.⁴

A bad debt can arise under a contractual agreement to pay a specific sum of money⁵ or under an obligation created by law.⁶ The requirements for determining whether a bad debt exists must be strictly met in order for the taxpayer to be entitled to claim the deduction.⁷

Since it must be determined with reasonable certainty that the bad debt has become worthless, a bad debt deduction is typically not permitted if the creditor voluntarily forgives the debt.

A legal action is not required to establish that a debt is worthless or unrecoverable. Where the surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action would in all probability not result in payment, a showing of these facts and circumstances will be sufficient evidence of the worthlessness of the debt.⁸

In determining whether a debt is worthless in whole or in part the IRS will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor.⁹

A taxpayer must make a reasonable inquiry, however, to ascertain whether the debt can be collected before claiming the bad debt deduction.¹⁰

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Planning Point: The parameters of what constitutes a “reasonable inquiry” into the collectability of a debt have certainly changed since the1938 court decision establishing that a “reasonable inference from information thus obtainable” satisfies the requirement. In today’s digital age, apparently no less than a comprehensive credit check of the debtor and an assessment of economic conditions affecting the debtor’s industry would likely suffice.

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A bad debt deduction is claimed for the tax year in which the taxpayer determines that the debt is worthless, not in the year that the debt actually became worthless.¹¹ For example, if
a debtor stopped making payments in 2024, but it was not until 2025 that the creditor-taxpayer determined that there was no reasonable chance that the debt would be paid, the bad debt deduction is properly claimed in 2025. A debtor’s declaration of bankruptcy is generally treated as an indication that the debt has become at least partially worthless if the debt is unsecured and not a preferred debt.¹²

If a taxpayer finds that a debt is worthless, but later discovers that he may be able to recover all or a portion of the debt, the bad debt deduction is not invalidated.¹³ Despite this, if a taxpayer has claimed a bad debt deduction, and subsequently finds that some amounts of the debt can be collected, the taxpayer is required to report any amounts collected on the debt as income.¹⁴

IRC Section 166(b) provides that the allowable deduction cannot exceed the creditor’s basis in the debt as provided under Treasury Regulation Section 1.1011-1 (which outlines the rules for determining adjusted basis for purposes of calculating gain or loss). Though a taxpayer’s
basis in a debt may be equal to the face value of the debt, this is not always the case. The regulations identify certain situations where the deduction will not equal the face value of the debt (for instance, the deduction for worthless receivables is based on the price paid by the purchaser of the receivables and not on their face value). ¹⁵