Do You Have to Pay Taxes on a Personal Loan?

A personal loan is money borrowed from a lender that the borrower agrees to repay over a set period, typically with interest. People often question whether these loans are considered taxable income, similar to wages or investment earnings. This article clarifies the general tax treatment of personal loans, from the principal amount received to interest payments and potential loan forgiveness scenarios.

The Non-Taxable Nature of Loan Principal

The principal amount received from a personal loan is generally not considered taxable income. This is because a personal loan creates a debt obligation, meaning the borrower is required to repay the funds. Unlike income earned from employment or investments, a loan does not increase the borrower’s net worth because it comes with an equal and offsetting liability. The money received is a temporary asset increase, balanced by a corresponding liability.

Borrowing money is a debt, not an accession to wealth that triggers a tax event. This means that when you receive the loan amount, you do not need to report it on your personal tax return.

When Loan Forgiveness Becomes Taxable

While the principal of a personal loan is not taxable, the situation changes if the loan, or a portion of it, is forgiven or canceled. When a lender forgives a debt, the amount forgiven can become taxable income to the borrower, a concept known as “Cancellation of Debt (COD) income.” This is because the borrower receives a financial benefit by no longer being obligated to repay funds, and the Internal Revenue Service (IRS) considers this amount as if it were income earned.

Lenders are typically required to report canceled debt of $600 or more to both the borrower and the IRS on Form 1099-C. Even if a borrower does not receive this form, they are still responsible for reporting the forgiven amount on their tax return. Common scenarios include debt settlement agreements or a lender deciding to write off an uncollectible debt.

There are specific exceptions where canceled debt may not be taxable. Two common exclusions are for insolvency and bankruptcy. If a borrower is insolvent, they may exclude the forgiven amount from income up to the extent of their insolvency. Debt discharged in a bankruptcy case is generally excluded from taxable income.

When these exclusions apply, the taxpayer generally needs to reduce certain tax attributes. Taxpayers claiming these exclusions must typically file IRS Form 982.

Tax Treatment of Interest Payments

Interest paid on a personal loan is generally not tax-deductible for the borrower. This contrasts with other types of interest, such as mortgage interest on a primary residence, qualified student loan interest, or interest on business loans, which may be deductible under specific circumstances. The reason for this distinction is that personal loans are typically used for personal expenses, and the tax code generally does not allow deductions for personal expenditures.

While there are exceptions, such as using a personal loan for qualified business expenses, educational expenses, or certain taxable investments, the interest deductibility only applies to the portion of the loan used for these specific purposes. However, for most individuals using personal loans for purposes like debt consolidation, home improvements, or unexpected personal costs, the interest paid does not reduce their taxable income.

Conversely, if an individual acts as a lender and receives interest payments on a personal loan they extended, that interest is generally considered taxable income to the lender. This interest income must be reported on the lender’s federal income tax return. If the amount is $10 or more, the payer may issue Form 1099-INT.