In this guide
- Interest Income: When You Must Report It
- Below-Market and Gift Loans: The IRS Rules
- Documenting the Loan: Why a Promissory Note Matters
- Bad Debt Deduction: When the Borrower Defaults
- Gift Loans and Forgiveness: Gift Tax Considerations
- Reporting Requirements and Recordkeeping
- State-specific promissory note guides
Interest Income: When You Must Report It
If you lend money and charge interest, the interest you receive is taxable income. You must report it on your tax return, even if the loan is informal and no promissory note exists. The IRS expects you to report all income, unless specifically excluded by law.
The amount of interest you report depends on the interest rate and the term of the loan. For most personal loans, you report the interest as 'other income' on Schedule 1 of Form 1040. If you are in the business of lending, you may need to report on Schedule C or other business forms.
Even if you don't actually receive the interest because the borrower fails to pay, you may still have to report it if it was constructively received or if you are on an accrual basis. Most individuals use the cash method, so you report interest only when you actually receive it.
- Report interest income on your tax return for the year it is received.
- Use Form 1099-INT if you receive $10 or more in interest from a bank or other institution, but for personal loans you may not receive a 1099; you still must report the income.
- If you charge a below-market interest rate, special rules may apply (see below).
- Keep a record of all loan payments, including interest, to substantiate your income.
Below-Market and Gift Loans: The IRS Rules
If you lend money at an interest rate below the 'Applicable Federal Rate' (AFR) set monthly by the IRS, the loan is considered a 'below-market' loan. The IRS may treat the foregone interest as if you received it and then gave it back to the borrower as a gift. This can create taxable interest income for you and potential gift tax consequences.
For loans of $10,000 or less, there is generally no tax impact if the loan is between individuals and not used for income-producing assets. For loans between $10,000 and $100,000, the rules are more complex: the foregone interest may be treated as a gift, but if the borrower has net investment income, you may have to report the foregone interest as income.
If your motive for the below-market loan is to make a gift, you may need to file a gift tax return if the total gifts for the year exceed the annual exclusion ($18,000 per person in 2024, but this amount changes). However, for loans, the gift is the foregone interest, not the principal.
- Check the AFR each month at IRS.gov to see if your loan rate is below market.
- For loans under $10,000, no tax issues usually arise.
- For loans over $100,000, the IRS will impute interest income to you regardless of the borrower's investment income.
- If you intentionally make a gift loan, consider consulting a tax professional to avoid surprises.
Documenting the Loan: Why a Promissory Note Matters
A written promissory note is crucial for tax purposes. It proves that the transfer was a loan, not a gift, which determines whether you have income or a bad debt deduction. Without a note, the IRS may treat the money as a gift, subject to gift tax rules, or as income to the borrower.
A proper promissory note should include the loan amount, interest rate, repayment schedule, maturity date, and signatures. It should also state whether the loan is secured or unsecured. This documentation helps you enforce the loan and supports your tax treatment.
If you later have to forgive the loan, a written note makes it clear that you are making a gift of the remaining balance, which may require a gift tax return if over the annual exclusion.
- Always use a written promissory note for any loan over $1,000.
- Include the AFR or a market rate to avoid imputed interest rules.
- Keep the note in your records for at least seven years after the loan is repaid or written off.
- A template can be found at legal self-help sites, but make sure it complies with your state's laws.
Bad Debt Deduction: When the Borrower Defaults
If a borrower fails to repay the loan, you may be able to deduct the unpaid amount as a bad debt on your tax return. However, to claim a nonbusiness bad debt deduction, the loan must be completely worthless, and you must have a legal right to collect it. You must also have a basis in the debt, which means you actually lent cash and reported any interest income.
For a nonbusiness bad debt, you treat it as a short-term capital loss on Schedule D. This deduction is limited to your capital gains plus up to $3,000 of ordinary income per year, with any excess carried forward to future years. You cannot claim a deduction for a loan that is merely partially worthless; it must be entirely uncollectible.
To prove worthlessness, you should document your collection efforts, such as demand letters, lawsuits, or bankruptcy filings. You must also show that there is no reasonable prospect of repayment. If the borrower is related to you, the IRS scrutinizes bad debt deductions more closely, so extra documentation is essential.
- Claim a nonbusiness bad debt as a short-term capital loss on Schedule D.
- The loan must be completely worthless in the year you claim the deduction.
- Document all collection attempts and the borrower's financial condition.
- If you are in the business of lending, you may claim an ordinary business bad debt deduction, which is more favorable.
Gift Loans and Forgiveness: Gift Tax Considerations
If you forgive a loan or make a loan with no intention of repayment, it may be considered a gift for tax purposes. The annual gift tax exclusion allows you to give up to a certain amount per person per year without filing a gift tax return. For 2024, the exclusion is $18,000, but this amount changes annually.
If the forgiven amount exceeds the annual exclusion, you must file Form 709 and may have to pay gift tax, though the lifetime exemption is high ($13.61 million in 2024). Most people will not owe gift tax, but they still must file if the gift exceeds the exclusion.
When you lend money and later forgive it, the forgiven amount is a gift from you to the borrower. The borrower does not have to report the forgiven debt as income unless the loan was for business or investment purposes and the borrower is insolvent or bankrupt. For personal loans, forgiveness is generally not taxable to the borrower.
- Track annual gifts to each person to stay under the exclusion.
- File Form 709 if any gift (including forgiven loan amounts) exceeds the annual exclusion.
- Consider structuring a loan with a low interest rate and periodic forgiveness to stay within the exclusion.
- Consult a tax advisor for large loans or complex family situations.
Reporting Requirements and Recordkeeping
You must report interest income on your tax return, but you are not required to issue a Form 1099-INT to the borrower unless you are a financial institution or a business that pays interest. For personal loans, you simply report the interest on Schedule 1. However, if you are in the trade or business of lending, you may need to issue 1099s.
If you have a loss from a bad debt, you must attach a statement to your return explaining the debt, the amount, and why it is worthless. The IRS has specific requirements for the statement, so follow the instructions for Schedule D.
Keep all loan documents, payment records, and correspondence for at least seven years. This includes the promissory note, bank statements showing the transfer, and any collection efforts. Good records are your best defense if the IRS questions your tax treatment.
- Retain a copy of the promissory note and all amendments.
- Record every payment, including interest and principal, in a spreadsheet.
- Save any emails or letters regarding the loan and its terms.
- If you claim a bad debt, keep evidence of the borrower's bankruptcy or insolvency.
- Use separate accounts for lending transactions to simplify tracking.