Declaring Bad Debt

You’ve probably heard the term before but you might not know what it means.  Investopedia says:

A debt that is not collectible and therefore worthless to the creditor. This occurs after all attempts are made to collect on the debt. Bad debt is usually a product of the debtor going into bankruptcy or where the additional cost of pursuing the debt is more than the amount the creditor could collect. This debt, once considered to be bad, will be written off by the company as an expense.

This definition implicitly defines a policy that is probably less aggressive than most businesses use.  When you declare bad debt you get to write it off against your income for the year, which reduces your tax burden.  Frequently, debts that are still probably collectible in the long run are still written off in order to save money today

The downside is the collection of bad debt, as you must declare the full amount as profit.  For example, if you buy a widget for $100 and sell it for $120 but aren’t repaid you will end up declaring a bad debt of $120 against a profit of $20 for a loss of $100.  You would have paid tax on $120 in profit and claimed $100 in expenses, in effect paying tax on $20 of income.  If you declared it as bad debt and are repaid the following year, you will have to pay income tax on $120 in income.  This sort of strategy needs to be be approached with a full understanding of your tax situation and what the pros and cons really are.