Bad Debt Deduction

If someone owes you money that you cannot collect, you may have a bad debt. For a discussion of what constitutes a valid debt, refer to Publication 550, Investment Income and Expenses, and Publication 535.

Business Expense

To deduct a bad debt, you must have previously included the amount in your income or loaned out your cash. If you are a cash basis taxpayer, as most individuals are, you may not take a bad debt deduction for income you expected to receive but did not because the amount was never included in your income. For a bad debt, you must show that there was an intention at the time of the transaction to make a loan and not a gift.

There are two kinds of bad debts – business and nonbusiness. A business bad debt, generally, is one that comes from operating your trade or business. A business deducts its bad debts from gross income when figuring its taxable income. Business bad debts may be deducted in part or in full.

All other bad debts are nonbusiness. Nonbusiness bad debts must be totally worthless to be deductible. You cannot deduct a partially worthless non-business bad debt. You must establish that you have taken reasonable steps to collect the debt and the debt is worthless. It is not necessary to go to court if you can show that a judgment from the court would be uncollectible.

You may take the deduction only in the year the debt becomes worthless. A debt becomes worthless when the surrounding facts and circumstances indicate there is no longer any chance the amount owed will be paid. You do not have to wait until a debt is due to determine whether it is worthless.

A non-business bad debt is reported as a short-term capital loss in Part 1 on Form 1040, Schedule D (PDF). It would be subject to the capital loss limitations. A non-business bad debt deduction requires a separate detailed statement attached to your return.

For information on non-business bad debts, refer to Publication 550, Investment Income and Expenses.

For information on business bad debts, refer to Publication 535, Business Expenses.

Tax Help - Reporting Your Investments

Reporting Your Investments

If you sold stocks, bonds, or mutual funds, then you need calculate your capital gains or losses when you file your Form 1040.

Investors need to have a firm grasp on how investments are taxed. Especially crucial is knowing the holding periods for short-term and long-term investments. The holding periods determine what tax rate will apply to your investments. Also important is figuring out your cost basis, which is the amount you invested in a security. Keeping excellent records and using a spreadsheet to keep track of your stock trades are vital for figuring out your holding period and cost basis.

One problem I see all the time is incomplete recordkeeping. The IRS requires taxpayers to be organized and keep good records of investments. Most crucial is having a record of your cost in various investments. Sometimes brokerage reports can help, but sometimes you'll need to dig this information up yourself. That's why I encourage investors to keep a copy of all their trade confirmations with their permanent tax files. Not only will good records help you monitor how your investments are performing, it will also make tax preparation infinitely easier.

Finally, don't pass up an opportunity to add to your investment portfolio. Invest your tax refund into a mutual fund or other long-term investment. I typically recommend my clients to split their tax refund into three equal portions: invest or save one-third, pay off debt with another third, and use the final third to reward yourself. The IRS has made this strategy of mine a little bit easier to accomplish. You can now split your refund and direct deposit it into two or three bank accounts. You can even use this feature to deposit some or all of your refund into an Individual Retirement Account.

FDIC Deposit Limits Precaution

One of the saddest situations that I have come across in my tax preparation experience was that of a 68 year old lady who had deposited over $165,000 into a credit union account. Several years afterward, the credit union went into receivership and she lost the excess $65,000 over the $100,000 deposit limit. Unfortunately, she can only take a loss of $3,000 per year until the $65,000 is exhausted. Think about it, she is 68 and at $3,000 per year it will take her 21.66 years to use the loss on her returns.

She should be a warning to others to keep an eye on their accounts to prevent their accounts from exceeding FDIC limits. So thanks for bringing this to our attention.How can folks avoid having more than $100,000 in any one bank or credit union with a risk of loss? If you have that much money, get really familiar with the FDIC rules.

http://www.fdic.gov/deposit/deposits/insuringdeposits/ and NCUA rules
http://webapps.ncua.gov/ins/InsuredFunds/YourInsuredFunds.htm

Either open accounts in several banks so they are all under the $100,000 limit, or open accounts in the names of different family members, or as joint accounts. Each account will be separately insured.

Note: If you put $100,000 into a CD or an account and it earns interest – you will lose the interest when the bank folds. So, deposit only $95,000 if the interest rate is 5%. And take out the interest each year. Or check with your insurance broker to see if you can get your own insurance to cover the failure of financial institutions. Or see if your financial institution carries additional insurance to cover their depositors. Then you won’t have to play Mickey Mouse games with your accounts.

Meanwhile, what can you do with the loss?

1) Get a copy of the paperwork showing how much was lost. Put a copy into the tax file for 2007, and keep it with your files until at least 6 years have passed.

2) Report it on Schedule D. http://www.irs.gov/pub/irs-pdf/f1040sd.pdfYour cost is the full amount of the CD. Your sale price is the amount your wife received instead of the full amount.

That’s the easy part.

The bad news is, that if she lost more than $3,000, you may have to spread that loss out over several years. The loss can be deducted against other capital gains you might have – plus $3,000 for each year. Chapter 16 of IRS Publication 17 explains how to report gains and losses http://www.irs.gov/publications/p17/ch16.html.

S. Raines, Sr. Tax Advisor/Tax Preparer

www.effectur.com