When Debt Is Worthless

You do not have to wait until a debt is due to determine whether it is worthless. A debt becomes worthless when there is no longer any chance the amount owed will be paid.

It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. You must only show that you have taken reasonable steps to collect the debt. Bankruptcy of your debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt.

Property received for debt. If you receive property in partial settlement of a debt, reduce the debt by the fair market value of the property received. You can deduct the remaining debt as a bad debt if and when it becomes worthless.

If you later sell the property, any gain on the sale is due to the appreciation of the property. It is not a recovery of a bad debt. For information on the sale of an asset, see Publication 544.

Example. Patti owed Margaret $5,000. In partial satisfaction of the debt, Patti gave Margaret property worth $2,000. Margaret deducted the remaining $3,000 as a bad debt but did not get a tax benefit from the deduction as she had no taxable income. Margaret later sold the property for a $1,000 gain. Even though Margaret did not get a tax benefit from the earlier bad debt deduction, she must include the $1,000 gain in her income. It is not a recovery of her bad debt.

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