Are Loan Proceeds Considered Taxable Income?
Borrowed money isn't income because it creates a liability. Learn about the tax implications that arise when that liability is removed or reduced.
Receiving a loan does not create taxable income. The funds you receive are not considered income because there is a corresponding legal obligation to pay the money back to the lender. This transaction is viewed as a debt, not a gain, meaning it does not increase your net worth. This principle applies whether the loan comes from a bank, credit union, or a family member, provided it is a genuine loan with an expectation of repayment.
For tax purposes, income is understood as an “accession to wealth.” When you receive loan funds, you also receive an equivalent liability. This means your overall financial position remains unchanged. Think of it like borrowing a neighbor’s lawnmower; you have temporary use of the equipment but are obligated to return it. Your personal assets have not permanently increased.
This contrasts with income sources like a paycheck, which is yours to keep without a repayment obligation. This represents a clear increase in your wealth and is what distinguishes taxable income from a non-taxable loan.
When a Loan Becomes Taxable Income
The tax treatment of a loan changes if the lender cancels or forgives a portion of the debt. When a lender discharges a debt for less than the full amount owed, the forgiven amount is considered Cancellation of Debt (COD) income by the Internal Revenue Service (IRS). This is because you have received a benefit by being released from the obligation to repay the money. The forgiven debt is no longer a loan but becomes income that must be reported.
A common example is the settlement of credit card debt. If you owe $10,000 on a credit card and the issuer agrees to settle the account for a payment of $4,000, the remaining $6,000 that was forgiven becomes taxable income. You have been relieved of the duty to pay back that $6,000, which the IRS views as an accession to wealth.
Another instance occurs with vehicle repossessions. If you have a car loan and default on the payments, the lender may repossess and sell the vehicle. If the sale price is not enough to cover the outstanding loan balance, a deficiency balance remains. Should the lender choose to forgive this deficiency, that forgiven amount is considered COD income.
Certain types of student loan forgiveness can also create taxable income, depending on the specific program’s rules. While some government-run forgiveness programs are explicitly exempt from taxation, forgiveness from a private lender or under a non-qualified program could result in the forgiven balance being treated as taxable income for the borrower.
Common Exclusions for Canceled Debt
Even if a debt is canceled, you may not have to pay tax on the forgiven amount if you qualify for an exclusion. The most used exclusion is for insolvency. The IRS considers you insolvent if, immediately before the debt cancellation, the total of all your liabilities was more than the fair market value (FMV) of all your assets. The amount of canceled debt you can exclude from income is limited to the amount by which you were insolvent.
To illustrate, assume your total liabilities are $70,000 and the FMV of your assets is $50,000, making you insolvent by $20,000. If a creditor cancels a $25,000 debt, you can exclude $20,000 of that canceled debt from your income. The remaining $5,000 would be reported as taxable income because it exceeds the amount by which you were insolvent.
Another exclusion applies to debts discharged in a Title 11 bankruptcy case, such as a Chapter 7 or Chapter 13 bankruptcy. The bankruptcy exclusion covers the entire amount of debt discharged as part of the bankruptcy proceedings, regardless of your financial position. This provides broad protection from COD income for those going through a formal bankruptcy.
An exclusion also exists for qualified principal residence indebtedness. This provision allows homeowners to exclude canceled mortgage debt on their main home, such as from a loan modification or foreclosure. For debt discharged before January 1, 2026, the maximum amount of forgiven debt that can be excluded from income is $750,000. For a married person filing a separate tax return, this limit is $375,000.
How to Report Canceled Debt on Your Tax Return
When a creditor forgives $600 or more of a debt, they are required to send you and the IRS a Form 1099-C, Cancellation of Debt. This form provides information regarding the event. Box 2 of the form shows the amount of debt that was discharged, and Box 1 indicates the date of the identifiable event that triggered the cancellation.
The taxable portion of the canceled debt is reported as “Other Income” on Schedule 1 of Form 1040. Even if you do not receive a Form 1099-C, you are still responsible for reporting any taxable COD income. The amount from Box 2 of the 1099-C is the starting point for what you report on your tax return.
If you qualify for an exclusion, such as insolvency or bankruptcy, you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. On this form, you will check the box that corresponds to your situation and enter the amount of the excluded debt. Attaching this form to your tax return is a necessary step to claim the exclusion, as the IRS may otherwise assume the full amount on the Form 1099-C is taxable.