Are Loans Taxed? Forgiven Debt, 401(k) Loans, and Family Loans

Loans are not taxed when you receive the money. The IRS doesn’t count borrowed funds as income because every dollar you take in comes with an equal dollar you owe back, so your net wealth hasn’t changed. Taxes enter the picture later: when interest accrues, when you claim a deduction, or when part of the debt is forgiven and you no longer have to repay it.

Why Borrowed Money Isn’t Income

Federal law defines gross income as “all income from whatever source derived,” a deliberately broad net.¹ Loan proceeds slip through that net for one reason: the cash you receive is matched by an equal obligation to repay. Your balance sheet moves on both sides by the same amount. No gain, no tax.

That logic also tells you where the tax will show up. The moment the repayment obligation shrinks, whether through settlement, forgiveness, or discharge, you’re holding money you don’t have to give back. That’s when the IRS has something to tax.

When Forgiven Debt Becomes Taxable

If a lender cancels, forgives, or settles a debt for less than you owe, the amount you no longer have to repay is generally ordinary income. The tax code lists “income from discharge of indebtedness” as a specific component of gross income.¹ Owe $40,000, settle for $25,000, and the remaining $15,000 is cancellation-of-debt income on your return.

This rule reaches into a lot of ordinary situations. Credit card settlements, negotiated reductions on medical bills, forgiven personal loans, and deficiency balances left over after a foreclosure can all trigger it. Starting in 2026, student loan forgiveness under income-driven repayment plans is taxable again, because the temporary exclusion under the American Rescue Plan Act applied only to discharges through December 31, 2025.²

Lenders who forgive $600 or more must report it to the IRS on Form 1099-C.³ Even if the form never reaches you, the tax obligation is still yours.

Exclusions That Can Shield You

Congress carved out several situations where cancelled debt is excluded from income.⁴ The two most common:

Debt discharged in a Title 11 bankruptcy case is fully excluded, no matter the amount.
If your total liabilities exceeded the fair market value of your total assets immediately before the cancellation, you can exclude the forgiven amount up to the degree of your insolvency. Someone insolvent by $30,000 can exclude up to $30,000.

Narrower exclusions cover qualified real property business debt, qualified farm indebtedness, and, historically, qualified principal residence indebtedness. The principal residence exclusion expired for discharges after December 31, 2025, and has not been renewed.⁵

An exclusion isn’t a free pass. In exchange for not paying tax now, you have to reduce certain tax benefits you’d otherwise carry forward, in a specific order set by IRS rules: net operating losses first, then various credits, capital loss carryovers, property basis, and so on.⁶ You report the reductions on Form 982.⁷ The practical result is deferral with a cost: a lost net operating loss means less shelter next year, a lower property basis means a bigger taxable gain when you sell.

Is the Interest You Pay Deductible?

The interest side of a loan is a different question. Whether you can deduct interest depends on what you used the borrowed money for. Personal interest, meaning credit cards, auto loans, and other consumer debt, is not deductible at all.⁸ That surprises people. Interest on a $30,000 car loan does nothing for you at tax time. The exceptions are where the real savings live.

Mortgage Interest

Interest on a mortgage secured by your primary home or a second home is deductible if you itemize, but the deduction is capped. For loans taken out after December 15, 2017, interest is deductible only on the first $750,000 of acquisition debt, or $375,000 if you’re married filing separately.⁸ Acquisition debt means money borrowed to buy, build, or substantially improve the home securing the loan.

Home equity debt follows the same purpose test. A home equity line used to renovate a kitchen qualifies. The same line used to pay off credit cards does not. Either way, the total mortgage debt has to stay under the $750,000 ceiling.

Student Loan Interest

You can deduct up to $2,500 per year in interest paid on a qualified education loan, and you don’t need to itemize to claim it.⁹ The deduction phases out at higher income levels based on modified adjusted gross income, with thresholds adjusted annually for inflation.¹⁰ Married couples must file jointly to claim it.

Business and Investment Interest

Interest on debt used to finance a trade or business is generally deductible as an ordinary business expense, though larger businesses face a cap tied to business interest income and 30 percent of adjusted taxable income. Small businesses that meet a gross receipts test are exempt from the limitation.¹¹

Interest on debt used to buy taxable investments, such as margin loans for stock, is deductible up to the amount of your net investment income for the year. Any excess carries forward indefinitely.⁸

Borrowing From Your 401(k)

Taking a loan from your 401(k) or similar employer plan isn’t taxable, provided you follow the rules. Break them and the loan converts into a taxable distribution with penalties attached.

Federal law limits plan loans to the lesser of $50,000 or 50 percent of your vested balance, with a $10,000 floor, and you must repay within five years through substantially equal payments made at least quarterly.¹² A loan used to buy your principal residence can run longer than five years.

Miss payments or leave your job with a balance outstanding, and the unpaid amount is treated as a “deemed distribution.” That’s ordinary income in the year of default, plus an additional 10 percent early distribution tax if you’re under 59½.¹³ Most plans give you a cure period, usually through the end of the quarter after a missed payment, to catch up before the deemed distribution locks in.

One detail catches people off guard: a deemed distribution doesn’t wipe out the loan. The balance stays on the books, accruing interest, until it’s actually repaid or offset against your account. You can owe tax on money you still owe back to your own retirement account.

Family Loans and Below-Market Interest

Loans between family members, an employer and employee, or a corporation and its shareholders get closer IRS scrutiny. When these related-party loans charge little or no interest, the IRS doesn’t accept the terms as written. It imputes interest, meaning it assumes a market-rate interest payment happened and taxes accordingly, even though no money changed hands.¹⁴

The benchmark is the Applicable Federal Rate, published monthly by the IRS, with short-term, mid-term, and long-term versions matched to the loan’s duration.¹⁵ If your loan charges less, the shortfall is treated as a transfer from lender to borrower and then back again as interest. That phantom interest creates taxable income for the lender. Depending on the relationship, the transfer to the borrower may also be treated as a gift, compensation, or a dividend.

A parent who lends a child $100,000 at zero interest is the textbook example. The IRS treats the forgone interest as a gift from parent to child, then recharacterizes it as interest income flowing back to the parent. The parent owes income tax on interest they never collected, and the gift may count against their lifetime gift tax exclusion.

There’s an escape hatch. Loans of $10,000 or less between individuals are generally exempt from imputed interest rules, and the same $10,000 threshold applies to compensation-related and corporate-shareholder loans.¹⁴ Above that, a written loan agreement that charges at least the AFR is the simplest way to keep the IRS out of the deal.

1
Office of the Law Revision Counsel. 26 U.S. Code 61 – Gross Income Defined
2
Taxpayer Advocate Service. What to Know About Student Loan Forgiveness and Your Taxes
3
Internal Revenue Service. About Form 1099-C, Cancellation of Debt
4
Office of the Law Revision Counsel. 26 U.S. Code 108 – Income From Discharge of Indebtedness
5
Internal Revenue Service. Publication 4681 (2025), Canceled Debts, Foreclosures, Repossessions, and Abandonments
6
eCFR. 26 CFR 1.108-7 – Reduction of Attributes
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Internal Revenue Service. Instructions for Form 982 – Reduction of Tax Attributes Due to Discharge of Indebtedness
8
Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest
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Office of the Law Revision Counsel. 26 U.S. Code 221 – Interest on Education Loans
10
Internal Revenue Service. Topic No. 456, Student Loan Interest Deduction
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Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
12
Internal Revenue Service. Retirement Plans FAQs Regarding Loans
13
eCFR. 26 CFR 1.72(p)-1 – Loans Treated as Distributions
14
Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans With Below-Market Interest Rates
15
Internal Revenue Service. Applicable Federal Rates