Are personal loans taxable and considered income?

What is a personal loan?

A personal loan is a type of unsecured loan you can use for a variety of purposes, from consolidating debt to financing a large purchase. The rate on a personal loan is usually fixed, meaning it won't change over the life of the loan, and you repay a personal loan in fixed monthly payments over a set period (typically two to five years).

» MORE: 5 best personal loans for good credit

What is taxable income?

Consumer finance expert Loretta Kilday, who works at DebtConsolidationCare, which provides free debt advice to consumers, defines taxable income as “any salaries, wages, freelancing income, tips and bonuses that a person earns over a year. …. The IRS defines income as any money you make, whether from a job or investments.”

Income can also be from not-so-obvious sources, such as the following:

• Free products received in exchange for reviews/promotion
• Prize winnings
• Interest earned on investments
• Capital gains from the sale of a home or asset
• Rental income

Are personal loans taxable or considered income?

Personal loans are not taxable or considered income in most cases because they are borrowed funds that you must pay back. They differ from earned income like wages or investment gains because there is an obligation to repay the money, usually with interest. When you take out a personal loan, you are essentially entering into a contract with a lender rather than receiving free or earned money.

However, there are exceptions. If any portion of the loan is forgiven or canceled by the lender, the IRS may consider that canceled debt as income. For example, if you borrowed $10,000 and your lender forgave $2,000 of the balance, you would likely need to report that $2,000 as taxable income.

This means you don’t have to report a personal loan on your taxes. However, if your lender ever cancels a portion or all of your loan, that will likely be considered income.

» MORE: Average personal loan interest rates

When a personal loan is taxable

There are certain circumstances when a personal loan can become taxable. The most common scenario is when part or all of the loan is forgiven or canceled by the lender, which the IRS treats as taxable income. Another situation to be aware of involves loans from family or friends, where the IRS may see forgiven amounts as gifts or income depending on how the transaction is handled. Understanding these scenarios is key to avoiding unexpected tax liability.

Cancellation of debt income

Debt can be canceled partially or completely through negotiations with the lender. While borrowers can do these debt negotiations themselves, many use a debt relief company or lawyer to negotiate on their behalf.

“The lender will issue a COD [cancellation of debt] and send you a 1099-C form if they decide to forgive your debt,” said Kilday, from DebtCC. “When you file your taxes with the IRS, you must include this form with your tax return to record the canceled amount.”

When a lender cancels or forgives all or part of your debt, the IRS considers that amount income.

It’s important to note that not all canceled debts are considered taxable income by the IRS. Some types of loan forgiveness programs may come with exceptions. If your debt is canceled as a gift or inheritance, or qualifies for farm indebtedness, you will not have to report the cancellation as income.

Debt canceled through bankruptcy does not have to be reported to the IRS.

Loans from family or friends

When you borrow money from family or friends, the IRS may view the transaction differently than a traditional bank loan. If the loan terms are not clearly documented with a repayment plan and interest, the IRS could classify the funds as a gift rather than a loan. If a portion of the loan is later forgiven, the forgiven amount could be considered a gift, which might require the lender to file a gift tax return if it exceeds the annual exclusion limit.

To avoid confusion or unexpected taxes, create a written agreement outlining the loan amount, repayment schedule and any interest charged. This documentation helps prove to the IRS that the money was a legitimate loan rather than income or a taxable gift.

Can I deduct the interest from my personal loan?

You may be able to deduct the interest from a personal loan on your taxes, depending on how you use the loan.

If you’re using the loan for certain business or investment purposes, such as purchasing equipment or investing in stocks, you can generally deduct the interest payments. However, if you took out the loan for personal reasons, such as for a car purchase or vacation, you cannot deduct the interest payments.

Some unique situations may allow for special deductions for personal loans. For example, if you're using a personal loan to fund an educational program — either undergraduate or graduate — at an eligible institution, then the interest payments you made during the year can be deducted from your taxes, up to certain limitations set by the IRS.

To determine your eligibility to deduct interest from a personal loan, speak with a qualified tax professional and provide them with all relevant information about your loan terms and details. They’ll be able to advise you on whether or not your specific situation allows for this tax deduction.

Bottom line

A personal loan is a form of debt, like a credit card balance or a mortgage. You must repay the money you borrowed with interest, and you don’t have to report the loan as income to the IRS. The only time you are taxed on the money you borrowed is if the lender forgives part or all of the loan.