Published Aug. 08, 2025 01:24AM EDT
Tax Savings for Bad Debts or Investments Going Bankrupt
If you regularly invest in at-risk companies or start-up companies in your own time or as an angel investor, then it is important to realize tax savings from when circumstances change. The IRS allows you to realize losses from bad debt or investments whether your interest is that of a stockholder or as a creditor.
When Does An Ownership Interest or Loan Become Worthless?
You do not need to wait until bankruptcy has been filed or a debt is deemed uncollectible by a court to realize the loss on your taxes. The IRS and courts take a totality of the circumstances approach to determining what year worthlessness occurs. As long as you can explain why the year in question is the year you realized the interest is worthless, you will be able to recognize the loss in that year. This usually will be something like filing Chapter 7 or missed payments but it can be anything that provides a reasonable basis for abandoning any hope of recovery.
Tax Treatment of the Loss.
Where you write off the loss depends on whether it is a business or nonbusiness investment. If it is an investment done in conjunction with a business you operate, such as a line of credit with a customer that has gone bankrupt, then it is deducted from the business’s gross income. There are enough nuances to this to warrant its own post.
For nonbusiness investments, though, the rules are a bit simpler. Nonbusiness bad debt is always considered a short-term capital loss. Equity interests, however, can be either a short- or long-term capital loss. The ownership interest is considered to be sold as of December 31 of the year it becomes worthless regardless of when the event making the interest worthless occurred. Thus, if the interest was acquired in the year the company became worthless, it is a short-term capital loss. Otherwise, it is a long-term capital loss.
Unique Requirements for Nonbusiness Debts.
Writing off nonbusiness debt does have some unique requirements. This type of debt is defined as any debt that does not arise from the operation of a business. To write it off, it must become wholly worthless—it is not adequate to have lost only part of its value. You must also show that it is an actual debt, rather than a gift. For this, the IRS often focuses on what pre-existing relationships there are between the debtor and creditor as well as whether there is any written agreement and market-rate interest being charged. You cannot write off a loan made to your minor child.
Given these additional requirements, when claiming a nonbusiness debt as worthless on your return, you will need to submit with your return a description of the debt, including the amount and the date it became due; the name of the debtor, and any business or family relationship between you and the debtor; the efforts you made to collect the debt; and why you decided the debt was worthless.
As always, it is advisable to consult with a tax attorney or preparer in deciding how the rules apply to your specific situation. Mid-Atlantic Law & Tax is happy to talk about your specific situation but, even if you do not reach out to us, please do worth with a professional to maximize your savings in a compliant manner.
