Do You Have to Pay Taxes on a Personal Loan?

When taking out a personal loan, the money you receive is not considered taxable income. The Internal Revenue Service (IRS) does not view loan proceeds as a gain in your personal wealth because a loan creates a liability—an obligation to repay the lender. Since you are expected to repay the funds, your net worth does not increase. This principle applies whether the loan comes from a bank, a peer-to-peer lending platform, or an individual.

Taxability of Loan Proceeds

The core reason loan proceeds are not taxed lies in the distinction the IRS makes between debt and income. Income is a financial gain that increases your wealth, such as wages or investment returns. A loan, conversely, does not make you wealthier because for every dollar you receive, a corresponding dollar of debt is created on your personal balance sheet. You have a legal obligation to repay the principal amount you borrowed. Your assets increase by the cash received, but your liabilities increase by the same amount, resulting in a net-zero effect on your overall financial worth. This is why funds from personal loans, mortgages, and even student loans are not immediately taxable.

Deductibility of Personal Loan Interest

While the loan itself is not income, a common question is whether the interest paid on that loan can be deducted from your taxes. For most personal loans, the answer is no. If you use the loan funds for purely personal expenses, such as a vacation, a wedding, or consolidating credit card debt, the interest you pay is considered a personal expense and is not deductible.

There are specific, limited situations where interest on a loan may be deductible. If you can trace the use of the loan proceeds directly to certain types of expenditures, you might qualify for a deduction. For instance, if you use a personal loan to fund business expenses, the interest may be deductible as a business expense. Similarly, if the funds are used for investment purposes, such as buying stocks, the interest may be deductible as an investment interest expense. Another exception applies to qualified student loans used for educational expenses.

Tax Implications of Loan Forgiveness

The tax treatment of a personal loan changes if the lender cancels or forgives a portion or all of the debt. When a lender forgives a debt, the forgiven amount is considered Cancellation of Debt Income (CODI) and becomes taxable to the borrower. This is because your obligation to repay the money has been removed, increasing your net worth.

If a lender forgives $600 or more of debt, they are required to send you and the IRS a Form 1099-C, Cancellation of Debt. You must report the canceled amount as “other income” on your U.S. Individual Income Tax Return, Form 1040. It is important to recognize that receiving a 1099-C does not automatically mean you will owe tax on the full amount, as certain exclusions may apply.

Exclusions for Canceled Debt

Even if you receive a Form 1099-C, you may not have to pay taxes on the canceled debt if you qualify for an exclusion. The two most common exclusions are bankruptcy and insolvency. If a debt is discharged in a Title 11 bankruptcy case, the canceled amount is not considered taxable income.

The other primary exclusion is insolvency, which applies if your total liabilities exceeded the fair market value of your total assets immediately before the debt was canceled. If your debts are greater than your assets, you are considered insolvent to the extent of that difference, and any canceled debt up to that amount is not taxable. For example, if your liabilities were $50,000 and your assets were $40,000, you would be insolvent by $10,000, and could exclude up to $10,000 of canceled debt from your income. To claim an exclusion for canceled debt, you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your tax return.