Nonbusiness Bad Debts

Nonbusiness Bad Debts

A bad debt loss not incurred in connection with a creditor's trade or business. A nonbusiness bad debt is deductible as a short-term capital loss and is allowed only in the year the debt becomes entirely worthless.
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The capital gain (loss) netting process, carryovers into the current year, carryovers into future years, the relationship of Form 8949 to Schedule D, Form 8949 transactions including worthless securities, nonbusiness bad debts, the preferential rate on long-term capital gains, and the 3.8% tax on net investment income may be addressed.
Two conditions must be met to deduct nonbusiness bad debts.
The IRS argued that these were nonbusiness bad debts. However, the Tax Court held these advances were contributions to capital of a joint venture and were deductible under IRC Sec.
166: business bad debts and nonbusiness bad debts. Business bad debts give rise to ordinary losses, while nonbusiness bad debts give rise to short-term capital losses (Secs.
Individual taxpayers may deduct two different types of bad debts: business bad debts, which are deductible as ordinary losses if completely or partially worthless, and nonbusiness bad debts, which are short-term capital losses taken only when entirely worthless.
However, the statute provides for different treatment for business and nonbusiness bad debts. Business debts are debts created or acquired in connection with a trade or business of the taxpayer or debt that is incurred in the taxpayer's trade or business; all other debts are nonbusiness debts.
Business bad debts result in ordinary losses; nonbusiness bad debts result in short-term capital losses.
This is typically preferable to the tax treatment of nonbusiness bad debts, which are deductible as a short-term capital loss in the year the debt becomes totally worthless.
166(d) provides that noncorporate taxpayers can claim short-term capital losses for nonbusiness bad debts. These are bad debts that do not qualify as business debts (i.e., debts not created or acquired in the ordinary course of a taxpayer's business or incurred in the taxpayer's business).
For individual taxpayers, bad debts are either (1) business bad debts, deductible as ordinary losses, or (2) nonbusiness bad debts, deductible as capital losses.
For noncorporate taxpayers, however, this allowance is qualified; losses attributable to nonbusiness bad debts are treated as resulting from the sale or exchange of capital assets held for not more than one year (i.e., short-term capital losses).
Business bad debts that are completely or partially worthless are deductible as ordinary losses, while nonbusiness bad debts are short-term capital losses only when entirely worthless.(1)