Borrowers can use personal loans for all kinds of purposes, but can the Internal Revenue Service (IRS) treat loans like income and tax them? The answer is no, with one significant exception: Personal loans are not considered income for the borrower unless the loan is forgiven.
In other words, you cannot be taxed on loan proceeds unless the lender grants the borrower a reprieve on paying back the debt owed. This is known as loan forgiveness. In the event a loan is forgiven, the proceeds associated with the original loan are considered a cancellation of debt (COD) income. And COD income can be taxed.
Key Takeaways
- Personal loans can be made by a bank, an employer, or through peer-to-peer lending networks, and because they must be repaid, they are not taxable income.
- If a personal loan is forgiven, however, it becomes taxable as cancellation of debt (COD) income, and a borrower will receive a 1099-C tax form for filing.
- Under certain circumstances, debt forgiveness is not considered COD income, such as when a loan from a private lender is forgiven as a gift or when qualified student loan debt is canceled when the recipient works for a period of time in certain professions.
Personal Loans
Personal loans can be loans made by a bank, an employer, or through peer-to-peer (P2P) lending networks. They can be used for just about anything by a borrower, but some common uses include consolidating debt, planning a wedding, or making other large purchases. While home loans and car loans offer collateral (the bank may take your home or car if you do not pay), personal loans are often unsecured, which means they are made with no collateral. As such, they are riskier, and interest rates therefore may be higher. But because personal loans must be repaid, they are not considered taxable income.
If you’re interested in taking out a personal loan but are uncertain what you can afford, then a personal loan calculator may prove useful in determining the right monthly payment amount, term length, and interest rate to suits your needs.
Cancellation of Debt (COD) Income
A debt is canceled when a lender allows a borrower to not pay back part or all of the loan. Debt cancellation can often be obtained by negotiating with the lender for relief, often due to financial distress, completing debt settlement programs, or filing for bankruptcy. Once a debt is forgiven, it is considered income. Borrowers should receive a 1099-C tax form.
Exceptions to the Rule of COD Income
However, there are a number of exceptions to the rule. If a loan is forgiven as a gift by a private lender, for example, there is no income to the borrower.
This rule has some additional stipulations. If a loan is forgiven as a gift to the amount of more than $16,000 in a year, then the total amount that’s forgiven chips away at the lifetime exemption from the gift tax (presently set at $11.7 million for 2021 and $12.06 million in 2022).
Debt canceled in a lender’s will does not count as COD income.
Source: Internal Revenue Service.
In the midst of the Great Recession, Congress passed the Mortgage Debt Relief Act of 2007. The act allowed taxpayers to exclude from their incomes any discharge of mortgage debt on their homes up to $2 million. The act applies for the years 2007 through 2017 and covers debt reduced through restructuring and foreclosure.
Workers employed in certain professions for a broad class of employers may also have their student loans canceled tax-free. In addition, some student loan repayment assistance programs, such as the one from the National Health Services Corps, are given tax-exempt treatment.
The American Rescue Plan passed by Congress and signed by President Biden in March 2021 includes a provision that student loan forgiveness issued between Jan. 1, 2021, and Dec. 31, 2025, will not be taxable to the recipient.
COD Strategies
There are several ways to arrange for the cancellation of a debt. As noted above, the most common include negotiating with creditors, completing a debt settlement program, and filing bankruptcy.
Negotiating with creditors is difficult, but at times provisions are written into a loan that allows borrowers to reduce their debt under certain circumstances, such as financial hardship. Debt settlement programs can be an option for borrowers who have consistently fallen behind on their payments. Borrowers work with a debt counselor to set up a payment program that, if completed, will result in the remaining debt being forgiven.