Do You Get Taxed on Loans? When a Loan Becomes Taxable

Receiving a loan principal is generally not considered taxable income. This is because a loan represents a temporary transfer of money that carries an obligation of repayment. While this principle holds true in most cases, specific circumstances can transform a loan into a taxable event, leading to unexpected tax liabilities for the borrower.

Understanding Why Loan Principal is Not Taxable

Loan principal is not taxable because it is a liability, not income. When you borrow money, your net worth does not increase as you incur a debt of equal value. It is not considered earned income, like wages, or an increase in wealth.

The obligation to repay borrowed funds distinguishes a loan from taxable income. Income typically refers to money or value received without a requirement to return it. A loan involves a clear agreement to repay the principal amount, often with interest, over a specified period. Therefore, receiving loan proceeds represents a temporary exchange of funds, not a taxable gain in wealth.

Situations Where Loans Can Become Taxable

Canceled or Forgiven Debt

When a debt is canceled, forgiven, or discharged for less than its full amount, the borrower generally recognizes this canceled amount as taxable income. This is commonly referred to as Cancellation of Debt (COD) income. Creditors often issue a Form 1099-C to both the borrower and the IRS if the canceled amount is $600 or more.

Common scenarios leading to COD income include debt settlements where a lender accepts less than the full amount owed, or situations involving foreclosure or repossession where the remaining deficiency balance is forgiven. For example, if a mortgage lender forgives a portion of a home loan after a short sale or foreclosure, that forgiven amount may become taxable. Student loan forgiveness can also be taxable, though federal student loan forgiveness has been temporarily exempt from federal taxation through the end of 2025. After 2025, forgiveness under income-driven repayment plans may become taxable again.

Several exclusions can prevent canceled debt from being taxable. If the debt is discharged in a Title 11 bankruptcy case or to the extent the taxpayer is insolvent immediately before the cancellation, the debt may be excluded from income. Insolvency means your total liabilities exceed the fair market value of your assets. For example, if $5,000 of debt is canceled but your liabilities exceeded your assets by $3,000, only $2,000 of the canceled debt would be taxable. Taxpayers claiming an exclusion for canceled debt, such as due to insolvency or bankruptcy, must file IRS Form 982 with their tax return.

Another exclusion applies to qualified principal residence indebtedness, which can be excluded from income for discharges occurring before January 1, 2026. This applies to debt reduced through mortgage restructuring or forgiven in connection with a foreclosure on a main home. The exclusion is limited to $750,000 ($375,000 if married filing separately) for discharges after December 31, 2020. Student loan cancellations due to specific work requirements or repayment assistance programs may also be nontaxable.

Below-Market Loans (Imputed Interest)

The IRS has rules to prevent tax avoidance through “below-market loans” with interest rates below market rates. In such cases, the IRS may “impute” interest, treating it as if it were paid, and require the lender to recognize this unstated interest as income. This concept ensures transactions reflect economic reality for tax purposes. The Applicable Federal Rate (AFR), published monthly by the IRS, determines the minimum interest rate that should be charged.

These rules commonly apply to gift loans between family members, employer-employee loans, and corporation-shareholder loans. For example, if a parent loans money to a child at zero interest, the IRS might consider the foregone interest as a gift from the parent to the child and then as interest paid back to the parent. This imputed interest would be taxable income for the lender.

De minimis exceptions apply. For gift loans between individuals, no imputed interest is required if the aggregate outstanding balance does not exceed $10,000, provided the loan is not used to purchase income-producing assets. For compensation-related and corporation-shareholder loans, a $10,000 threshold applies, unless a principal purpose of the loan was tax avoidance.

Loans from Retirement Plans

Taking a loan from a retirement plan, such as a 401(k), is generally not a taxable event if certain conditions are met. These conditions include repayment within a five-year term, unless the loan is for purchasing a primary residence, which may allow a longer period. The loan amount is capped, at the lesser of $50,000 or 50% of the vested account balance. Repayments must be made at least quarterly.

A 401(k) loan can become a taxable distribution if these terms are not followed. If the loan is not repaid according to the agreed-upon schedule, or if the borrower leaves their job and fails to repay the outstanding balance within a specified timeframe, the unpaid amount is treated as a taxable distribution. This distribution is subject to income tax and, if the individual is under age 59½, may also incur a 10% early withdrawal penalty. This penalty applies unless an IRS exception is met, such as separation from service at age 55 or older.

Loans Reclassified as Gifts or Compensation

The IRS examines the true nature of a financial transaction to determine its tax implications. If a purported “loan” lacks a genuine intention of repayment, the IRS may reclassify it as a gift or compensation, which would then be taxable to the recipient. Indicators that a transaction may not be a true loan include the absence of a formal loan agreement, a defined repayment schedule, or the charging of interest.

If a loan is reclassified as a gift, the giver may be subject to gift tax rules if the amount exceeds the annual gift tax exclusion. For 2025, this exclusion allows an individual to give up to $19,000 per recipient without gift tax implications. Amounts exceeding this annual exclusion reduce the giver’s lifetime gift and estate tax exemption, which is $13.99 million per individual for 2025. If a loan from an employer to an employee is reclassified as compensation, the full amount becomes taxable income to the employee and is subject to income and employment taxes, similar to wages.