Personal loans are not treated as borrowers’ income. But in cases where the lender forgives the borrower of the loan, it is considered as income. This means that the borrower cannot be taxed personal loan proceeds except in a situation where he/she receives loan forgiveness. In such circumstances, the income from the original loan is considered as ‘cancelation of debt’ income. This implies that the cancellation of debt income is taxable. The COD rule, however, has various exemptions which are discussed below.
If the borrower is a student, cancellation of debt on a student loan is exempted from the rule in certain circumstances. For example, if the student works for qualifying employers in some profession for a specified period of time.
The rule does not apply where the lending is between relatives or family members. This exception is after the IRS considers the debt as inheritance and not a gift. But in situations where there are strict working or business relations, the COD rule applies.
If the borrower is declared bankruptcy formally during the cancellation of debt, the rule will not apply.
If immediately prior to cancellation of debt the borrower is insolvent, the rule does not apply. Insolvency is a situation where the outstanding debt is more than the market value of the borrower’s assets. The exclusion will be limited to the difference between the cancelled debt and the market value of the assets.
Death of the Lender
In case of death of a private lender, the cancellation of debt rule exemption will apply if the lender indicates in the will that the debt is cancelled.
In situations where the interest charged by the borrower is not enough or not the interest is not charged, IRS will figure out what interest would the loan be charged then treat as if the borrower incurred. It is a requirement that the lender reports interest as part of taxable income.
However, where the lender charges low or no interest to its borrowers, some tax issues will arise. But, this usually is not a problem since any unpaid interest is always treated as gifts to the borrower, which is tax-free. This is possible only if the total due interest amount is less than the tax exclusions on gifts which is currently at $13, 000.
The important thing to note is that given some exceptions, the rule does not apply of amounts less than $10,000. Further, if the loan amount is $100,000 or less, the interest the lender is required to report is restricted to the net investment of the borrower in the year. If the net investment of the borrower is less than or equal to $1,000, the interest amount is considered as zero.
In some instances, the lender may forgive the loan, and the borrower will not be required to repay the whole or a portion of the loan. In such a case the whole amount forgiven will be considered as a gift. It will, therefore, be subjected to gift tax lifetime or annual exclusions.
Forgiveness can be done once if the lender is not likely to exceed their lifetime limit. But if the lender is not willing to forgive the loan at once because they want the lifetime exclusions to be preserved, they will forgive the principal amount to a limit of $13,000 each year until the entire amount is forgiven.