Bad Debt Recovery: Definition and Tax Treatment

What Is Bad Debt Recovery?

Bad debt recovery refers to a payment received for a debt that had previously been written off and considered uncollectible. Because bad debt usually generates a loss when it is written off, bad debt recovery generally 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 company's books.

How Bad Debt Recovery Works

Bad debts are difficult or impossible to collect, so they're often written off by the debt holder. In most cases, a company or lender will have taken many steps before classifying a debt as "bad," including in-house and third-party collections or even legal action. Collection efforts may continue even after the debt has been written off.

When a full or partial repayment of a debt is received after it has been written off, that's referred to as a bad debt recovery. A bad debt might be recovered through a payment from a bankruptcy trustee or because the debtor has decided to settle the debt at a lower amount.

A bad debt may also be recovered if an asset used as collateral is sold. For example, a lender may repossess a car and sell it to pay the outstanding balance on an auto loan. A bank may also receive equity in exchange for writing off a loan that could later result in a recovery of the debt and, perhaps, additional profit.

Bad debt is all but 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 Business Bad Debt Recovery to the IRS

Any action taken with regard to a 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 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. If a portion of the deduction did not trigger a reduction in the company's tax bill, it 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, because of a net operating loss (NOL). These losses carry over for a set number of years before they expire. If a company's bad debt deduction triggered an NOL carryover that has not expired, that constitutes a tax reduction, and 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.

Reporting Non-Business Bad Debt Recovery to the IRS

In some cases, the IRS allows tax filers to write off non-business bad debts. These debts must be completely not collectible, and the taxpayer must be able to prove they 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 adequate 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 non-business 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, they only need to report an amount equal to the bad debt deduction that reduced their tax obligation in the year they claimed the bad debt.

The Bottom Line

Businesses and individuals can write off bad debts on their taxes. If the bad debt is later repaid, however, they will have to report the amount they deducted as income.