Are Personal Loans Taxed? What You Need to Know

A personal loan provides a lump sum of money for various purposes, from consolidating debt to covering unexpected expenses. Many people mistakenly assume the loan amount itself is taxable income. This article clarifies the tax treatment of personal loans and when they might impact your taxes.

Understanding Loan Proceeds and Income

The principal amount received from a personal loan is generally not considered taxable income by the Internal Revenue Service (IRS). A loan represents a debt that must be repaid, not earnings or profit. When you borrow money, you incur an obligation to return it, which means it does not increase your net worth in a way that triggers income tax. Unlike wages or investment gains, loan proceeds are not earned income. You do not need to report the money you borrow on your personal tax return, regardless of the financial institution providing the loan.

Interest Payments and Tax Deductions

Interest paid on personal loans is typically not tax-deductible for the borrower. This is because personal loans are often used for personal expenses, and the IRS generally does not allow deductions for personal expenditures. For example, interest paid on car loans or credit card balances for personal use is also usually not deductible. However, interest on qualified student loans, mortgage interest on a primary residence, or loans used for business expenses can sometimes be deducted. For a standard personal loan used for general personal needs, the interest payments will not reduce your taxable income.

Tax Implications of Loan Forgiveness

While receiving a personal loan is not taxable, a significant exception arises if the loan, or a portion, is forgiven or canceled. When a lender forgives a debt, the amount you no longer have to repay is generally considered “cancellation of debt (COD) income” and must be reported as taxable income. The IRS views this as income because you received a financial benefit.

Common scenarios include a lender agreeing to accept less than the full amount owed, or a debt being discharged in bankruptcy proceedings. For example, if you owe $5,000 on a personal loan and the lender settles for $2,000, the $3,000 difference is typically considered COD income. This canceled debt is generally reported as ordinary income on Form 1040.

Several exclusions exist where canceled debt may not be taxable. Debt discharged in a Title 11 bankruptcy case, such as Chapter 7 or Chapter 13, is generally not considered taxable income. Another common exclusion applies if you were insolvent immediately before the debt was canceled. Insolvency means your total liabilities exceeded the fair market value of your total assets. In such cases, the amount of canceled debt can be excluded from income to the extent of your insolvency.

Reporting for Canceled Debts

If a lender forgives a certain amount of debt, they are generally required to issue Form 1099-C, Cancellation of Debt, to both the borrower and the IRS. This form is typically issued when the canceled debt amounts to $600 or more. Form 1099-C notifies you and the IRS that a specific amount of debt has been canceled and may be taxable income. Lenders must send Form 1099-C to taxpayers by January 31 of the year following the debt cancellation. Even if you do not receive a Form 1099-C for canceled debt over $600, you are still responsible for reporting the amount on your tax return. If you believe you qualify for an exclusion from COD income, you may need to file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your tax return.