Do You Have to Pay Taxes on Interest From Personal or Family Loans?
Image: Bigstock
Lending money to friends or family may feel like a simple arrangement, but the Internal Revenue Service (IRS) does not always see it that way. If you collect interest on a personal loan, that money is generally taxable, even if no bank or financial institution is involved. And if you do not properly structure the loan, the IRS may even treat it as a gift.
That is why understanding the tax rules surrounding personal and family loans is crucial. The line between a loan and a gift is not always clear, and the wrong setup may lead to unexpected tax consequences for the lender.
What Counts as a Personal or Family Loan?
A personal loan in this context typically refers to lending money to someone you know, often a family member or friend. These loans are common for big expenses such as buying a house, covering emergencies or starting a business.
While a genuine loan is not considered taxable income for the borrower, the IRS expects lenders to treat interest collected as taxable income. Even if you do not receive a 1099-INT form, you are still responsible for reporting that interest on your return.
Here’s How the IRS Decides Whether it is a Loan or a Gift
The key question is whether the arrangement qualifies as a legitimate loan. If the IRS decides it is really a gift, different tax rules kick in. To prove that it is a loan, three main conditions matter:
A written agreement:The IRS looks for documentation that clearly defines the loan amount, repayment terms and interest rate. Without it, the transaction may look too casual to qualify as a loan.
A repayment schedule:You need a clear timeline for repayment. If no schedule exists and the money is not paid back, the IRS may treat the balance as a gift.
Charging interest:Even if you want to help a loved one with an interest-free loan, the IRS requires you to charge at least a minimum interest rate, known as the Applicable Federal Rate (AFR). If you do not, the missing interest is treated as a gift to the borrower.
When Does Interest Become a Tax Issue?
Once you charge interest, that income must be reported on your tax return. The IRS does not overlook personal arrangements, and failing to report this income may trigger problems later.
On the flip side, if you do not charge interest and the loan amount is large enough, the IRS may calculate “imputed interest.” That’s the interest they think you should have charged and they will treat it as taxable income, even if you never collected it.
Important Exceptions to Know
The IRS does give some leeway when it comes to smaller loans:
Loans under $10,000:If the total loan amount is under this threshold and is not used to generate income (such as investing in a business), you do not need to charge interest or report it as a gift.
Loans under $100,000:For loans below this amount, interest requirements depend partly on the borrower’s investment income. If the borrower earns less than $1,000 from investments in a year, you may not need to charge interest. Otherwise, you must apply the lesser of the AFR or their net investment income.
Why Structuring the Loan Matters
The takeaway is straightforward: if you want the IRS to view the transaction as a loan, you must treat it accordingly. Put the terms in writing, set a repayment schedule and charge interest at or above the AFR. Doing so protects you from having the loan reclassified as a gift and helps you avoid tax complications.
Without these steps, what started as a generous act may end up triggering gift taxes or forcing you to pay taxes on interest you never even received.
Final Thoughts
Helping out a friend or relative with a personal loan can be a good deed, but it is not free from tax considerations. For the lender, interest income is taxable and informal agreements risk being treated as gifts. By documenting the loan properly and meeting IRS requirements, you can avoid unpleasant surprises at tax time.