Borrowers can use personal loans for all kinds of purposes. But can the Internal Revenue Service (IRS) treat loans like income and tax them? Not really, but sometimes. 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 “cancellation of debt” (COD) income. COD income can be taxed.
Personal loans can be loans made by a bank, employer or through peer-to-peer lending networks. They can be used for just about anything the borrower wants, 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 or made with no collateral. As such, the interest rates may be higher. Because personal loans are repaid, they are not considered taxable income.
Cancellation of Debt Income
Cancellation of Debt (COD) occurs when a lender allows a borrower to not pay back part or all of a debt. Debt relief or cancellation can often be obtained by negotiating with the lender to 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 is no hard-and-fast definition of COD income, as there are some exceptions to the rule. If a loan is forgiven as a gift by a private lender, 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 $13,000 in a year, then the total amount forgiven chips away at the $1 million lifetime exemption from the gift tax. In the case of the death of a lender, debt canceled in the lender’s will does not count as income.
In response to the mortgage crisis of 2007-2008, the U.S. Congress exempted up to $2 million in mortgage debt in the advent of foreclosure. If a debt is discharged due to filing bankruptcy, it does not count as income. The same is true for insolvency status. Following matriculation from an educational institution, it is also possible for student loans to be forgiven depending on the former student’s employer and field of employment.
There are several ways to arrange for the cancellation of a debt. The most common include negotiating with creditors, completing a debt relief program and filing bankruptcy.
Negotiating with creditors is difficult, but at times provisions are written into the loan that allows borrowers to reduce their debt under certain circumstances, such as financial hardship. Debt relief programs can be an option for borrowers that 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.