How to write off a promissory note that will never be repaid

You lent money on a signed note, the borrower stopped paying, and every reasonable attempt to collect has failed. The tax code gives you a consolation prize called the nonbusiness bad debt deduction. It's real, it's useful, and it's also one of the more frequently disallowed deductions on individual returns because people skip the proof. This guide walks through what the Internal Revenue Service (IRS) requires, how the loss is treated, and what to keep in your file so the write-off survives a question letter.

The loan has to have been a loan

The first hurdle is the genuine-debt test. The IRS only lets you deduct a debt if there was a real obligation to repay a fixed or determinable sum. A signed promissory note is the best evidence you can have here, because it names the parties, the amount, the interest rate, and the due date. Money handed to a friend with a vague "pay me back when you can" is much harder to defend, and money handed to a relative is harder still. Publication 550 tells you plainly that if you lend to a relative and it isn't a real loan, the IRS treats it as a gift, and gifts can't be deducted as bad debts.

Courts and auditors look at the same signals every time: Was there a written note? Did it carry interest? Was there a repayment schedule? Did the borrower actually make some payments? Did you act like a lender when payments stopped? An unsecured note with a stated rate and a maturity date checks most of those boxes on day one. If you're reading this before the loan is made, that's the single most valuable thing you can do.

The debt must be totally worthless, not just late

Nonbusiness bad debts must be totally worthless before you can deduct anything. IRS Topic 453 is blunt about it: a partially worthless nonbusiness debt gets no deduction at all. That rule separates personal lenders from businesses, which can write down a debt in pieces. So a borrower who is six months behind but still employed and still answering the phone hasn't produced a deductible loss yet. A borrower who has filed bankruptcy, vanished, or died with no estate usually has.

You don't have to sue to prove worthlessness. The standard is whether a reasonable person would conclude there's no realistic chance of collection. A bankruptcy discharge, a returned demand letter, a judgment you can't collect on, or a borrower with no assets and no income all support that conclusion. What won't work is simply deciding you're tired of asking.

Pick the right tax year

The deduction belongs in the year the debt became totally worthless, not the year you gave up or the year the note matured. This trips people up because worthlessness is a judgment call and the facts often develop over time. If you claim the loss too early, the IRS can say the debt still had value. Claim it too late and you've missed the year entirely, though the IRS does allow a longer window than usual to amend a return for a bad debt. Keep dated records of every collection step so you can point to the specific event that ended any hope of repayment.

It's a short-term capital loss, with a cap

Here's the part that disappoints lenders. A nonbusiness bad debt isn't deducted against wages like a business expense. Topic 453 says it must be treated as a short-term capital loss, reported on Form 8949, Part I, and it's subject to the capital-loss limits. Publication 550 puts that limit at $3,000 per year against ordinary income ($1,500 if you're married filing separately), after netting against any capital gains you had. Anything above that carries forward to later years.

So a $30,000 note that goes bad in a year when you have no capital gains gives you a $3,000 deduction this year and a $27,000 carryforward. That's still worth claiming. It just isn't a windfall, and it's a reason to run the numbers on a loan payoff calculator before you lend more than you can afford to lose slowly.

How to report it on your return

Topic 453 spells out the mechanics. On Form 8949, Part I, line 1, enter the debtor's name and the words "bad debt statement attached" in column (a). Put your basis in the debt (usually the unpaid principal you actually lent) in column (e), and put zero in column (d). Use a separate line for each bad debt. Accrued interest you never received and never reported as income isn't part of your basis, so you can't deduct it.

The statement itself is not optional. The IRS expects a written attachment that covers four things: a description of the debt including the amount and the date it was due, the name of the debtor and any business or family relationship to you, the efforts you made to collect, and why you decided the debt was worthless. Two short paragraphs will do if they're specific. Vague language like "borrower could not pay" invites follow-up.

What to keep in the file

Assume you'll need to show your work three years from now. Keep the signed note, proof the money left your account, any payment history, every demand letter and its delivery confirmation, texts or emails where the borrower acknowledges the debt, and whatever documents establish worthlessness (the bankruptcy notice, the returned mail, the collection agency's report). If the note was governed by a state with a short limitations period, such as Texas, note the date the claim expired too; an unenforceable debt is strong evidence of a worthless one. Our statute of limitations lookup covers each state.

How business bad debts differ

Topic 453 draws the line this way: a bad debt is a business bad debt if it came from operating your trade or business, or if the main reason for the loan was closely related to the business. Everything else is nonbusiness. Business bad debts get better treatment on two fronts. They're deducted as ordinary business expenses (on Schedule C for a sole proprietor) with no $3,000 cap, and they can be deducted when partially worthless. The catch is that you must have already included the amount in income or lent actual cash; a cash-basis business can't deduct an unpaid invoice it never reported.

A loan from an individual to a company they don't operate is almost always nonbusiness, even if the borrower was a business. The question is your motive and activity, not the borrower's.

Before you lend the next dollar

The deduction is a backstop, not a plan. Charge at least a modest interest rate, set a real due date, get a signature, and keep copies. Check that the rate is legal with the usury limit checker, because an unenforceable note is harder to defend as a genuine debt. If the loan goes bad anyway, you'll have the paper trail the IRS expects, and the write-off will hold up.

Sources

• IRS Topic 453, Bad Debt Deduction
• IRS Publication 550, Investment Income and Expenses
• IRS Instructions for Form 8949