Reg. § 1.166-3 Partial or total worthlessness.
(a) Partial worthlessness
(1) Applicable to specific debts only A deduction under section on account of partially worthless debts shall be allowed with respect to specific debts only.
(2) Charge-off required
(i) If, from all the surrounding and attending circumstances, the district director is satisfied that a debt is partially worthless, the amount which has become worthless shall be allowed as a deduction under section but only to the extent charged off during the taxable year.
(ii) If a taxpayer claims a deduction for a part of a debt for the taxable year within which that part of the debt is charged off and the deduction is disallowed for that taxable year, then, in a case where the debt becomes partially worthless after the close of that taxable year, a deduction under section shall be allowed for a subsequent taxable year but not in excess of the amount charged off in the prior taxable year plus any amount charged off in the subsequent taxable year. In such instance, the charge-off in the prior taxable year shall, if consistently maintained as such, be sufficient to that extent to meet the charge-off requirement of section with respect to the subsequent taxable year.
(iii) Before a taxpayer may deduct a debt in part, he must be able to demonstrate to the satisfaction of the district director the amount thereof which is worthless and the part thereof which has been charged off.
(3) Significantly modified debt
(i) Deemed charge-off If a significant modification of a debt instrument (within the meaning of ) during a taxable year results in the recognition of gain by a taxpayer under , and if the requirements of of this section are met, there is a deemed charge-off of the debt during that taxable year in the amount specified in of this section.
(ii) Requirements for deemed charge-off A debt is deemed to have been charged off only if—
(A) The taxpayer (or, in the case of a debt that constitutes transferred basis property within the meaning of section , a transferor taxpayer) has claimed a deduction for partial worthlessness of the debt in any prior taxable year; and
(B) Each prior charge-off and deduction for partial worthlessness satisfied the requirements of and of this section.
(iii) Amount of deemed charge-off The amount of the deemed charge-off, if any, is the amount by which the tax basis of the debt exceeds the greater of the fair market value of the debt or the amount of the debt recorded on the taxpayer's books and records reduced as appropriate for a specific allowance for loan losses. The amount of the deemed charge-off, however, may not exceed the amount of recognized gain described in of this section.
(iv) Effective date This applies to significant modifications of debt instruments occurring on or after September 23, 1996.
(b) Total worthlessness If a debt becomes wholly worthless during the taxable year, the amount thereof which has not been allowed as a deduction from gross income for any prior taxable year shall be allowed as a deduction for the current taxable year.
[T.D. 6500, 25 FR 11402, Nov. 29, 1960, as amended by T.D. 8763, 63 FR 4396, Jan. 29, 1998]