What is a Bad Debt Recovery
A bad debt recovery is business debt from a loan, credit line, or accounts receivable that is recovered either in whole or in part after it has been written off or classified as a bad debt. Because it generally generates a loss when it is written off, a 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.
BREAKING DOWN Bad Debt Recovery
Not all bad debt recoveries are like-kind recoveries. For example, a collateralized loan that has been written off may be partially recovered through sale of the collateral, or a bank may receive equity in exchange for writing off a loan, which could later result in recovery of the loan and, perhaps, some additional profit.
How to Report Bad Debt Recoveries to the IRS
If a business writes off a bad debt in one tax year and recovers some or all of the debt in a following tax year, the Internal Revenue Service (IRS) requires the business to 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 did 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, but they create 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, thus, the bad debt recovery must 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.
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 that 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 that the debtor is insolvent or has declared bankruptcy is significant proof. For example, if someone lent his 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, and the taxpayer may report is 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.