Promissory Note Tax Implications: What You Need to Know

A promissory note is more than just a written promise to repay a loan—it also carries tax consequences for both lenders and borrowers. Whether it’s a personal loan, business financing, or a real estate transaction, the IRS has specific rules on how these notes are taxed.

Classification under Tax Regulations

The IRS categorizes promissory notes based on their purpose, structure, and the relationship between the parties. These classifications determine taxation and reporting requirements. A note issued in a business setting, such as a corporate loan or seller-financed transaction, is generally treated differently from a personal loan. Business-related notes are often subject to ordinary income taxation, while personal loans may have different implications depending on whether they qualify as bona fide debt.

To be recognized as legitimate debt rather than a disguised gift or equity investment, a note must have a fixed repayment schedule, an expectation of repayment, and consequences for nonpayment. If it lacks these characteristics, the IRS may reclassify it, potentially triggering gift tax liabilities or altering tax treatment for both parties. This distinction is especially relevant in family loans, where informal agreements can lead to unintended tax consequences.

In business transactions, promissory notes can be classified as recourse or non-recourse debt. Recourse debt holds the borrower personally liable, allowing the lender to pursue other assets if the borrower defaults. Non-recourse debt limits the lender’s recovery to the collateral securing the loan. This classification affects how losses are treated for tax purposes, particularly in real estate and investment scenarios.

Recognizing Interest Income

Lenders must report interest received on a promissory note as taxable income. The IRS requires interest income to be recognized in the year it is received or accrued, depending on the taxpayer’s accounting method. Cash-basis taxpayers report interest when they receive payment, while accrual-basis taxpayers recognize it when it is earned, regardless of when the payment is received.

The interest rate stated in the note determines taxable income. Fixed-rate notes require lenders to report the exact interest received, while variable-rate notes, which adjust based on an index like the prime rate, require tracking rate changes for accurate reporting. If payments are irregular, such as in balloon-payment structures, lenders must account for the timing of income recognition to avoid underreporting.

If a promissory note is sold before maturity, the seller must recognize accrued but unpaid interest as income. This interest must be separated from the principal when determining taxable gain or loss. If a lender sells a note mid-year, any interest earned up to that point must still be reported as income, even if the new holder receives the actual payment.

Imputed Interest Requirements

The IRS enforces imputed interest rules to prevent taxpayers from avoiding taxable income by structuring loans with artificially low or no interest. These rules apply to below-market loans, where the interest rate falls below the applicable federal rate (AFR) set monthly by the Treasury. If a loan does not meet the AFR threshold, the IRS recharacterizes part of the transaction as interest, requiring the lender to report taxable income even if no actual payments were received.

This applies to personal loans, intra-family lending, and business financing. For example, if a parent lends a child $200,000 interest-free, the IRS treats the foregone interest as taxable income to the lender. The borrower may also be considered to have received a taxable gift or compensation, triggering additional tax consequences. The AFR varies based on loan term length—short-term (under three years), mid-term (three to nine years), and long-term (more than nine years)—so structuring a loan with an appropriate rate helps avoid imputed interest complications.

Exceptions exist for loans under $10,000 if the borrower does not use the funds for investment income. Demand loans, which allow the lender to request repayment at any time, are subject to fluctuating AFRs, making compliance more complex. When a loan is subject to imputed interest, the lender must report the income annually, even if payments are deferred until maturity. This can create cash flow challenges, as tax liabilities arise without corresponding cash receipts.

Borrower’s Deduction Eligibility

Interest deductions depend on the nature of the debt and how the borrowed funds are used. The IRS generally allows deductions for business, investment, and qualified personal loans, but restrictions apply based on classification and substantiation. Interest on loans used to acquire, maintain, or improve investment property can typically be deducted under Internal Revenue Code 163(d), subject to limitations that cap deductions at net investment income. Borrowers must maintain precise records linking the loan proceeds to deductible expenses to avoid disallowance.

For businesses, interest on loans used for operational expenses, asset purchases, or capital improvements is deductible under Internal Revenue Code 162, provided the debt serves a legitimate business purpose. However, the deduction may be limited under the business interest expense limitation in Internal Revenue Code 163(j), which caps deductions at 30% of adjusted taxable income for certain taxpayers. Small businesses with average annual gross receipts under $29 million (as of 2024) are exempt, making proper debt classification important for maximizing deductions.

Capital Gains on Note Transfers

Selling or transferring a promissory note may trigger capital gains tax depending on the difference between the note’s adjusted basis and sale price. The adjusted basis typically reflects the original loan principal, reduced by any principal repayments. If the note is sold for more than its basis, the seller realizes a capital gain, taxed based on the holding period—short-term if held for one year or less, and long-term if held for more than a year, with preferential tax rates applying to long-term gains.

If a note is sold at a discount, meaning the transfer price is lower than the remaining principal balance, the seller may recognize a capital loss. Deductibility depends on whether the note was held for investment or personal purposes. Investment-related losses may offset other capital gains, while personal losses are generally non-deductible. If the note was originally issued at a discount, such as in seller-financed transactions where the face value exceeds the purchase price, the original lender may have to account for original issue discount (OID) rules, which require gradual income recognition over the life of the note rather than at the time of sale.

Documenting for Compliance

Proper documentation ensures tax compliance and helps defend the legitimacy of a promissory note in an IRS audit. The agreement should clearly outline repayment terms, interest rates, and collateral provisions, aligning with IRS standards to prevent reclassification as a gift or equity investment. Maintaining records of payments, accrued interest, and any modifications to the note is equally important, as discrepancies can lead to penalties or disallowed deductions.

For businesses, promissory notes should be integrated into financial statements in accordance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), depending on the reporting framework. This includes recognizing interest income or expense appropriately and ensuring that any imputed interest is accounted for. In family or informal lending arrangements, documenting the transaction through formal agreements and consistent payment tracking can help avoid IRS scrutiny and unintended tax consequences.