Income and Assets · Property, real and personal

Non-business bad debts

The rule is short and the consequences are severe. A debt that is not connected with a trade or business and goes bad is not deductible as a bad debt at all: it is a short-term capital loss, however many years it was outstanding, deductible only against capital gains and the annual allowance. It is allowed only when the debt is wholly worthless, never in part. And if there was never a real debt — which is where most family loans end up — there is no deduction of any kind.

The rule

A nonbusiness debt is taken out of § 166(a) and recharacterised. For a taxpayer other than a corporation, the general bad debt deduction does not apply to a nonbusiness debt; where such a debt becomes worthless within the taxable year, the resulting loss is treated as a loss from the sale or exchange, during that year, of a capital asset held for not more than 1 year (IRC § 166(d)(1)(A), (B)). The holding period is imposed by the statute, so a fifteen-year-old loan produces a short-term loss.

What makes a debt nonbusiness. Any debt other than one created or acquired in connection with the taxpayer’s trade or business, or one whose worthlessness is incurred in that trade or business (IRC § 166(d)(2)). Whether a debt is nonbusiness is a question of fact, and the test is whether the loss bears a proximate relation to a trade or business the taxpayer is carrying on at the time the debt becomes worthless (Treas. Reg. § 1.166-5(b)).

And what the debtor does with the money is irrelevant. The regulation says so expressly: “The use to which the borrowed funds are put by the debtor is of no consequence” (Treas. Reg. § 1.166-5(b)). Lending to someone else’s business does not make the debt a business debt of the lender.

There must be a real debt. Only a bona fide debt qualifies — one arising from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money. A gift or a contribution to capital is not a debt (Treas. Reg. § 1.166-1(c)). The fact that the debt is not yet due does not by itself prevent the deduction.

All or nothing. A loss on a nonbusiness debt is treated as sustained only if and when the debt has become totally worthless, and no deduction is allowed for a nonbusiness debt recoverable in part during the year (Treas. Reg. § 1.166-5(a)(2)). The partial-worthlessness route in § 166(a)(2) is closed to it.

The amount is basis, not face value. The deduction is measured by the adjusted basis provided in § 1011 for determining loss on a sale (IRC § 166(b)). For a cash-method lender, accrued but unpaid interest was never in income, has no basis, and produces nothing.

A worthless security is a different provision. Where a security that is a capital asset becomes worthless, the loss is treated as from a sale or exchange on the last day of the taxable year (IRC § 165(g)(1)) — which can convert a short holding into a long-term loss. A debt described in § 165(g)(2)(C) is expressly outside the nonbusiness bad debt rules (Treas. Reg. § 1.166-5(b), final sentence).

And there is a longer period to claim it. A claim for credit or refund relating to the deductibility of a worthless debt or security, or to its effect on a carryover, has a seven-year period of limitation in place of the ordinary one (IRC § 6511(d)(1)).

Current figures

How it works in practice

The first question is not whether the debt is bad but whether it was a debt. A family advance with no note, no interest, no repayment schedule and no attempt at collection is a gift, and Treas. Reg. § 1.166-1(c) puts a gift outside § 166 entirely. Contemporaneous documentation — a written note, a stated rate, a schedule, and evidence of demands for payment — is what separates a deductible loss from nothing at all, and it has to exist before the loan goes bad.

The second is timing, and it cuts both ways. Because only total worthlessness counts, claiming too early is fatal: a debt still partly collectible produces no deduction in that year. Claiming too late loses the year. The seven-year period in § 6511(d)(1) exists precisely because worthlessness is hard to date, and it is the reason a late-discovered bad debt can still be claimed by amending a return that would otherwise be closed.

The third is what the loss is worth. A short-term capital loss offsets capital gains without limit and then ordinary income only up to the annual allowance, with the excess carried forward. A client expecting to deduct a 50,000-dollar failed loan against salary should be told early that this takes many years absent capital gains.

How this has changed

The regulation still cites a repealed subsection. Treas. Reg. § 1.166-5(a)(1) denies a deduction “under either section 166(a) or section 166(c)”. Section 166(c) — the reserve method for bad debts — was repealed by Pub. L. 99-514 § 805(a) in 1986, and the bracketed repeal note now stands in its place in the statute. The regulation’s rule is unaffected, but one of the two provisions it names has not existed for forty years.

The same regulation still carries its pre-1977 holding periods. Paragraph (a)(2) reads “a capital asset held for not more than 1 year (6 months for taxable years beginning before 1977; 9 months for taxable years beginning in 1977)”. Those parentheticals are dead text preserved in a live rule — harmless, but a reminder that the regulation has not been touched in decades.

What has not changed is the effect of the short-term characterisation, and inflation has made it harsher. The annual capital loss allowance against ordinary income has stood at the same figure since 1986, so the practical value of a nonbusiness bad debt deduction has fallen steadily in real terms. The statute recharacterises the loss and a separate, unindexed provision then limits it.

The seven-year refund period is easy to overlook and rarely mentioned. Section 6511(d)(1) doubles and more the ordinary window for exactly the situation this topic produces — a loss whose correct year is disputed or discovered late.

Exam focus

Expect the character to be the whole question, with a long-held loan in the facts inviting a long-term answer. It is short term by statute.

Expect a family loan with no documentation, where the answer is that there was no debt.

Expect a partial recovery, testing whether you know the nonbusiness rules require total worthlessness.

Distinguish a worthless security from a bad debt: § 165(g) deems the sale on the last day of the year, which can produce a long-term loss on the same facts.

Check yourself

1. A taxpayer’s properly documented personal loan of 30,000 dollars, made eight years ago, becomes wholly worthless. What is the character of the loss?

Answer: A short-term capital loss. IRC § 166(d)(1)(B) treats a worthless nonbusiness debt as a loss from the sale of a capital asset held not more than one year, regardless of how long it was outstanding.

2. The same taxpayer recovers 40 percent of a different loan and expects the rest to be lost. May a partial deduction be taken?

Answer: No. Treas. Reg. § 1.166-5(a)(2) allows the loss only if and when the debt becomes totally worthless, and denies any deduction for a nonbusiness debt recoverable in part during the year.

3. A cash-method lender is owed 20,000 dollars of principal and 3,000 dollars of accrued interest, all worthless. What is deductible?

Answer: 20,000 dollars. IRC § 166(b) measures the deduction by adjusted basis under § 1011, and interest never included in income has no basis.

4. Does lending money to a friend’s business make the debt a business debt?

Answer: No. IRC § 166(d)(2) looks to the lender’s trade or business, and Treas. Reg. § 1.166-5(b) states that the use to which the debtor puts the funds is of no consequence.

5. A taxpayer discovers in 2026 that a debt actually became worthless in 2021. Is a claim still possible?

Answer: Potentially yes. IRC § 6511(d)(1) provides a seven-year period of limitation for a refund claim relating to the deductibility of a debt that became worthless, in place of the ordinary period.