What Is Bad Debt Recovery?
Bad debt recovery is a payment received for a debt that was written off and considered uncollectible. The receivable may come in the form of a loan, credit line, or any other accounts receivable.
Because it generally generates a loss when it is written off, bad debt recovery usually produces income. In accounting, the bad debt recovery credits the allowance for bad debts or bad debt reserve categories and reduces the accounts receivable category in the books.
Understanding Bad Debt Recovery
Many bad debts are difficult to collect and are often written off. In most cases, a company has taken many steps before deeming it a bad debt including in-house and third-party collections or even legal action. Collection efforts may still take place after the debt is written off.
Payment can still be made after the debt is written off, making it a bad debt recovery. Payment may come as partial payment from a bankruptcy trustee or because the debtor has decided to take a settlement to clear off the debt at a lower amount.
The bad debt may also be recovered if a piece of collateral is sold. For example, a lender may repossess a car and sell it to pay for the outstanding loan. A bank may also receive equity in exchange for writing off a loan that could later result in a recovery of the loan and, perhaps, additional profit.
[Important: Additional fees such as bailiff charges and attorney fees may be added to the debt.]
Bad debt is inevitable, as companies will always have customers who won't fulfill their financial obligations. That's why there is a high demand for bad debt recovery companies or (third-party) collection agencies.
Reporting Bad Debt Recoveries to the IRS
Any action taken with the bad debt must be noted in the company's books. When the debt is written off, it must be accounted for as a loss. If it is recovered, the company must reverse the loss.
So when a business writes off a bad debt in one tax year and recovers some or all of the debt in the following tax year, the Internal Revenue Service (IRS) requires the business include the recovered funds in its gross income. The business only has to report the amount of the recovery equal to the amount it previously deducted. However, if a portion of the deduction does not trigger a reduction in the business's tax bill, the business does not have to report that part of the recovered funds as income.
In some cases, bad debt deductions do not reduce tax in the year they are incurred, creating a net operating loss (NOL). These losses carry over for a set number of years before they expire. If a business's bad debt deduction triggered an NOL carryover that has not expired, that constitutes a tax deduction, and the bad debt recovery must thus be reported as income. However, if the NOL carryover has expired, the business essentially never received the tax reduction and does not need to report the corresponding recovery.
- Bad debt recovery is a payment received for a debt that was written off and considered uncollectible.
- All or part of a bad debt may be made in the form of a payment from a bankruptcy trustee or when the bank sells collateral.
- Bad debts must be reported to the IRS as a loss. Bad debt recovery must be claimed as part of its gross income.
Recovering Nonbusiness Bad Debts
In some cases, the IRS allows tax filers to write off nonbusiness bad debts. These debts must be completely not collectible, and the taxpayer must be able to prove he did as much as possible to recover the debt. However, the filer does not have to take the debtor to court.
In most cases, showing the debtor is insolvent or has declared bankruptcy is significant proof. For example, if someone lent a friend or neighbor money in a transaction completely unrelated to either of their businesses, and the borrower failed to repay the loan, that is a nonbusiness bad debt. The taxpayer may report it as a short-term capital loss.
If the debt is repaid after it was claimed as a bad debt, the tax filer has to report the recovered funds as income. However, he only needs to report an amount equal to the bad debt deduction that reduced his tax obligation in the year he claimed the bad debt.