Are loans taxable? You’re probably wondering how a loan you’re about to take would affect your tax. But before attempting to understand the tax implications of a loan, answer this basic question. What is a loan? It’s a sum of money that you borrow, and are expected to repay in due course. So, whether it’s a personal loan or any other type of loan, you take up the responsibility to repay it. Therefore, although a loan appears to be an income, in reality it’s not. And this is the primary reason why loans per se are not taxable.
But, there are exceptions to this rule.
When is a loan taxable?
For the most part, when you take a personal loan or any other loan, taxes don’t come into play. However, in some situations it may be treated as income. For instance, if the lender releases you from the liability to repay your loan’s principal or interest, it becomes an income. This is called Cancellation of Debt (COD) income, and is taxable. In this case, you need to report the amount to the IRS and pay tax on it.
When does COD take place?
Debt cancellation may take place when you can no longer afford to repay the borrowed amount. In such a situation, you may negotiate with the lender for debt settlement/cancellation. In case of mortgage loans, debt cancellation occurs when there is a foreclosure, repossession, voluntary transfer of property, mortgage modification, or abandonment of property. When such a loan is forgiven or cancelled, the lender gives you the form 1099-C to report the cancelled debt amount to the IRS.
Exceptions to the COD Income Rule
There are many circumstances when cancelled debt may not be counted as taxable income, including:
- Debts cancelled as a gift, bequest, or inheritance
- Student loans forgiven under certain provisions that require you to serve in a government or public service position for a stipulated period of time
- Debts discharged due to filing of bankruptcy or insolvency
What to do once your debt is cancelled/ forgiven?
If your loan does not come under any of the above exceptions, your lender will send you the form 1099-C at the end of the tax year. This form is for reporting income. When you file your income for the tax year, you should report income from debt cancellation to the IRS. If you fail to do so, you run the risk of getting a tax bill, or much worse, an audit notice. So the next time you think of debt settlement for your personal loan or any other loan, don’t forget how it affects your tax!