Are Loans Included in Gross Income?
Loan proceeds are not income due to the obligation to repay. Learn the tax rules for when canceled debt becomes taxable and what important exceptions may apply.
The money you receive from a loan is not included in your gross income because it creates an obligation to repay the funds. Since you must pay the money back, the Internal Revenue Service (IRS) does not consider it an “accession to wealth.” You have more cash on hand, but you also have an equal and offsetting liability on your personal balance sheet.
This principle applies to conventional loans, whether you are taking out a mortgage, financing a vehicle, or receiving a personal loan. The transaction is based on the mutual understanding that the amount will be returned, usually with interest. Tax implications arise only when this obligation to repay is altered or forgiven.
The Tax Treatment of Bona Fide Loans
For a transaction to be respected as a non-taxable loan by the IRS, it must qualify as a “bona fide” loan. This term signifies that the arrangement is a genuine debt, created with the real expectation of repayment. The IRS examines several factors to distinguish a true loan from other financial transfers that could be disguised as gifts or income.
A primary indicator of a bona fide loan is a formal, written loan agreement or a promissory note. This document should outline the loan amount, a repayment schedule, and the interest rate. If a loan carries an interest rate significantly below the Applicable Federal Rates (AFR) published by the IRS, it may be re-characterized.
Beyond the documentation, the actions of both the borrower and lender matter. Consistent payments made according to the agreed-upon schedule further substantiate the loan’s legitimacy. Without these elements, the IRS could argue that the transfer was not a loan, but rather a taxable event, such as a dividend if from a corporation or a gift if between individuals.
Cancellation of Debt as Taxable Income
The tax-free nature of a loan changes if the lender cancels or forgives the debt for less than the full amount owed. When you are no longer required to repay what you borrowed, the forgiven portion can become taxable income. This is known as Cancellation of Debt (COD) income.
This situation can arise in common scenarios. For instance, if you have a credit card with a $10,000 balance and the company settles the account for a payment of $4,000, you have received $6,000 in COD income. The same logic applies to other debts, such as car loans, medical debt, or personal loans.
The amount of income you must recognize is the difference between the outstanding debt before the cancellation and any amount you paid to settle it. The forgiven debt is treated as ordinary income, which is taxed at your regular marginal tax rate.
Exclusions for Canceled Debt Income
While canceled debt is generally taxable, several exclusions may allow you to avoid paying taxes on it. These exclusions must be claimed properly on your tax return and are designed to provide relief in specific situations.
- Bankruptcy: Debt discharged in a Title 11 bankruptcy case, such as a Chapter 7 or Chapter 13 filing, is not considered taxable income.
- Insolvency: You can exclude canceled debt income up to the amount by which you are insolvent. You are insolvent when your total liabilities exceed the fair market value of your total assets immediately before the debt cancellation.
- Qualified Principal Residence Indebtedness: The discharge of mortgage debt on your main home can often be excluded from income.
- Student Loans: Specific student loan forgiveness programs, such as Public Service Loan Forgiveness (PSLF), provide for the tax-free cancellation of debt for borrowers who meet program requirements.
Tax Reporting for Canceled Debt
When a lender cancels a debt of $600 or more, they are required to send you and the IRS a Form 1099-C, Cancellation of Debt. This form reports the amount of canceled debt and other details about the transaction. Receiving a Form 1099-C is a strong indication that the IRS has been notified of the potential income.
If the canceled debt is taxable, you report it as “Other Income” on Schedule 1 of your Form 1040. This amount then flows to your main tax form and is included in your adjusted gross income. Do not ignore a Form 1099-C, as the IRS will likely match the information to your tax return, and failing to report the income could lead to penalties and interest.
If you qualify for an exclusion, you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your tax return. On this form, you will indicate which exclusion you are claiming and calculate the amount of canceled debt being excluded from your income.