Is a Personal Loan Taxable? Exceptions to the Rule

A personal loan involves borrowing money from a lender, such as a bank or credit union, with an agreement to repay the borrowed amount, usually with interest, over a set period. The general rule is that receiving money from a personal loan does not constitute taxable income. However, certain situations can alter this principle, leading to unexpected tax liabilities. This article clarifies the tax treatment of personal loans, outlining when they might become taxable and the tax considerations for loan interest.

Understanding Loan Principal Taxation

The money you receive as the principal amount of a personal loan is generally not considered taxable income. This is because a loan represents a debt obligation, not a gain or earnings. You are expected to repay the amount borrowed, making it a liability rather than income. The Internal Revenue Service (IRS) views the loan principal as a temporary transfer of funds that must be returned. Since you are not increasing your net worth permanently, the borrowed amount does not fall under the definition of taxable income. This principle applies to legitimate loans with a clear expectation of repayment and agreed-upon terms.

Scenarios When a Loan Becomes Taxable

While the principal of a personal loan is typically not taxable, specific circumstances can cause a loan or a portion of it to become taxable income. One common situation is loan forgiveness, also known as cancellation of debt (COD) income. If a lender forgives or cancels all or part of your debt, the amount forgiven is generally considered taxable income because you have benefited from not having to repay it.

When a commercial lender forgives a debt of $600 or more, they are required to issue Form 1099-C, Cancellation of Debt, to both you and the IRS, reporting the forgiven amount. This income must then be reported on your tax return. Exceptions to this rule include debt discharged in bankruptcy or if you were insolvent at the time the debt was canceled.

Another scenario involves non-bona fide loans, particularly those between individuals. If an arrangement lacks a clear repayment expectation, a formal agreement, or an interest rate, the IRS might reclassify it. This reclassification could lead to the transaction being treated as a gift or, in some cases, taxable income if it’s from an employer or business. For example, if a supposed loan from a family member is never intended to be repaid, it could be reclassified as a gift. While gifts are generally not taxable to the recipient, if the gift exceeds the annual exclusion amount (e.g., $18,000 per recipient in 2024), the giver may have gift tax reporting obligations.

Tax Considerations for Loan Interest

The tax implications for personal loan interest differ depending on whether you are the borrower or the lender. For borrowers, interest paid on personal loans is generally not tax-deductible. This contrasts with interest on certain other loan types, such as qualified student loans, mortgages, or business loans, which may be deductible under specific conditions. Personal expenses, including the interest paid on personal debt, are not deductible from your taxable income.

If you are the lender and charge interest on a personal loan, that interest income is generally taxable to you. You are required to report this interest as income on your tax return. If you lend money to a friend or family member at an interest rate below the Applicable Federal Rate (AFR) set by the IRS, the IRS may “impute” interest. This means the IRS may consider you to have received interest income at the AFR, even if you did not actually collect it, and you may be taxed on that imputed amount.

Maintaining Loan Records

Effective record-keeping is important for managing personal loans, for both the borrower and the lender, to substantiate the loan’s legitimacy and navigate potential tax implications. Key documents to retain include the original loan agreement or promissory note, which outlines the terms, repayment schedule, and interest rate. Keeping records of all payments made or received, such as bank statements or canceled checks, is also important.

Any correspondence related to the loan, including modifications to terms or agreements for partial forgiveness, should be kept. These records serve as evidence to the IRS that the transaction was a legitimate loan with a clear obligation for repayment. Proper documentation is especially important if the loan is ever questioned by tax authorities, helping to avoid reclassification as a gift or taxable income, particularly in scenarios involving loan forgiveness.