Hoffman, Smith, and Willis, CPAs
5191 Natorp Boulevard
Mason, OH 45040
January 29, 2009
Mr. John Johnson
100 Tyler Lane
Erie, PA 16563
Dear Mr. Johnson:
This letter is to inform you of the possibility of taking a bad debt deduction.
Your loan to Sara is a nonbusiness bad debt; therefore, you are not allowed to take a bad
debt deduction for partial worthlessness. You will be able to take a bad debt deduction in
the year in which the debt becomes wholly worthless.
Should you need more information or need to clarify anything, please contact me.
John J. Jones, CPA
TAX FILE MEMORANDUM
January 29, 2009
John J. Jones
Bad Debt Deduction
John Johnson’s $30,000 loan to Sara is a nonbusiness bad debt. Therefore, a bad debt
deduction is not allowed for partial worthlessness. John will be able to claim a bad debt
deduction in the year when the debt becomes wholly worthless.
pp. 7-4 and 7-5
Sue must include the $5,000 in gross income, but only to the extent of a tax benefit in the
prior year. Because the debt is a nonbusiness bad debt, the $8,000 would have been
treated as a short-term capital loss. As such, $1,000 of the bad debt would have applied
against the $1,000 of long-term capital gain. An additional $3,000 would have offset
ordinary income. Therefore, the tax benefit would have been $4,000 and hence, $4,000 of
the $5,000 collected would be included in Sue’s gross income. pp. 7-3 to 7-5
The potential bad debt is limited to Sally’s basis in the debt.
Because she paid $60,000
for the account and collected $65,000, she has no bad debt.
In fact, she must recognize
income of $5,000 ($65,000 – $60,000).
§ 1244 ordinary loss (limit of $100,000)
Short-term capital gain on § 1244 stock