The tax implications of a promissory note fall on both sides of the loan and stretch across its whole life. The lender owes ordinary income tax on the interest as it comes in; the borrower may or may not be able to deduct that same interest, depending entirely on what the borrowed money was used for. On top of that baseline, forgiveness creates taxable income for the borrower, below-market rates between relatives trigger imputed interest, notes taken back in a property sale are taxed on the installment method, and selling or inheriting a note has its own rules. Here is how each piece works.
Interest Income for the Lender
Interest earned on a promissory note is ordinary income, taxed at your regular income tax rates. When you report it depends on your accounting method. Most individual lenders use the cash method and report interest in the year they actually receive it. If a borrower or paying agent pays you $10 or more in interest during the year, you should receive a Form 1099-INT.1Internal Revenue Service. About Form 1099-INT, Interest Income The tax is owed whether the form arrives or not.
Accrual-method lenders, typically businesses, report interest as it accrues over the life of the note, whether or not the borrower has actually paid.
Original Issue Discount
If a note is issued for less than its face value (a zero-coupon note, or one carrying a stated rate below the market rate), the built-in difference is original issue discount, and it is treated as interest. The lender has to include a portion of that discount in income every year, even when no cash changes hands until maturity.2Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount Each year’s recognized OID is added to your basis in the note, which matters if you later sell it or write it off.
Interest Deductions for the Borrower
Loan proceeds themselves are not income to the borrower; you have to pay the money back. The question is whether the interest you pay is deductible, and that turns on how you used the money.
- Money used in a trade or business: the interest is deductible as a business expense.
- Money used to buy investment property: the interest is deductible as investment interest, but only up to your net investment income for the year. Any excess carries forward.3Internal Revenue Service. Form 4952 – Investment Interest Expense Deduction
- Money used for personal purposes: not deductible.
The main exception to the personal-use rule is qualified mortgage interest. If the note is secured by your primary or second home and the proceeds were used to buy, build, or substantially improve that home, you can deduct interest on up to $750,000 of debt ($375,000 if married filing separately) for loans taken out after December 15, 2017. Loans from before that date keep a $1 million cap.4Internal Revenue Service. Publication 936 (2025), Home Mortgage Interest Deduction
Where OID applies, the borrower’s yearly OID deduction mirrors the lender’s yearly OID income inclusion, so both sides move in step even before cash actually passes.
When the Borrower Defaults
If a borrower stops paying and the debt becomes uncollectible, the lender can potentially claim a bad debt deduction. The treatment depends on whether the loan was tied to a business.
A business bad debt, such as a loan a supplier extends to a customer, is deductible against ordinary income and can be claimed when the debt is wholly or partially worthless.5Office of the Law Revision Counsel. 26 USC 166 – Bad Debts You do not have to wait until every dollar is clearly gone.
A non-business bad debt, the kind that comes from lending to a friend or relative, is treated much less generously. It can only be deducted when the debt is completely worthless, and the loss is a short-term capital loss no matter how long you held the note.6Internal Revenue Service. Topic No. 453, Bad Debt Deduction Report it on Form 8949 and Schedule D. Capital losses offset your capital gains plus up to $3,000 of ordinary income per year ($1,500 if married filing separately), and any leftover carries forward.7Internal Revenue Service. Topic No. 409, Capital Gains and Losses
Missed payments are not enough. To claim the deduction, you need to show there is no reasonable chance of recovery, which means documented collection efforts and evidence of the borrower’s financial condition. Skipping that step is where most personal lenders lose the deduction.
When the Lender Forgives the Debt
If a lender forgives all or part of what you owe, the forgiven amount is generally ordinary taxable income to you. Owe $100,000, settle for $60,000, and you have $40,000 of cancellation of debt income. Lenders report canceled debt of $600 or more on Form 1099-C,8Internal Revenue Service. Form 1099-C (Rev. April 2025) Cancellation of Debt and you report the income whether or not the form ever reaches you.9Internal Revenue Service. Topic No. 431, Canceled Debt – Is It Taxable or Not?
Exclusions That May Apply
Several statutory exclusions can keep canceled debt out of income, each with strings attached:10Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness
- Debt discharged in a Title 11 bankruptcy is fully excluded.
- Insolvency: if your liabilities exceeded the fair market value of your assets immediately before the discharge, you can exclude COD income up to the amount of that insolvency.
- Qualified farm indebtedness owed to a qualified lender can be excluded within limits tied to tax attributes and property basis.
- Qualified real property business indebtedness (secured by real property used in a trade or business, for taxpayers other than C corporations) can be excluded, in exchange for reducing the basis of your depreciable real property.
- Qualified principal residence indebtedness covers forgiven mortgage debt on your main home, but only for discharges before January 1, 2026, or under a written arrangement entered into before that date.11Internal Revenue Service. Instructions for Form 982 – Reduction of Tax Attributes Due to Discharge of Indebtedness
The trade-off for most exclusions is a required reduction of tax attributes such as net operating losses, credit carryovers, or the basis of your property, generally dollar for dollar in a prescribed order. You can elect to reduce depreciable-property basis first. The exclusion is claimed on Form 982.
The temporary rule that made student loan forgiveness federally tax-free expired at the end of 2025. Forgiveness received in 2026 is taxable at the federal level.
Family and Other Below-Market Loans
Loans between relatives (or between an employer and employee, or a company and its shareholder) at zero interest or a rate below the Applicable Federal Rate are treated as below-market loans, and the IRS supplies the missing interest through a process called imputation.12Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
The AFR is a set of minimum rates the IRS publishes each month in three tiers: short-term (three years or less), mid-term (over three through nine years), and long-term (over nine years). For reference, the April 2026 annual-compounding AFRs are roughly 3.59% short-term, 3.82% mid-term, and 4.62% long-term. Check the rate in effect for the month the note is issued.
In a family loan, imputation runs like this: a parent lends $200,000 to a child at 0% on a long-term note. The parent is treated as having received AFR interest and then given that same amount back to the child. The parent reports phantom interest income, and the deemed gift can also carry gift-tax reporting.
Small-Loan Exceptions
Two dollar thresholds keep smaller family loans out of the imputation rules:
- Gift loans directly between individuals of $10,000 or less are exempt, as long as the total balance between the two people stays at or below $10,000. This exemption disappears if any of the money is used to buy or carry income-producing assets.
- For gift loans between $10,001 and $100,000, the imputed interest the lender must report is capped at the borrower’s actual net investment income. If that net investment income is $1,000 or less, it counts as zero, so no interest is imputed at all. The cap goes away once outstanding loans between the parties exceed $100,000.
Gift Tax Side of the Same Transaction
The imputed interest is also treated as a gift from lender to borrower. For 2026, the annual gift tax exclusion is $19,000 per recipient.13Internal Revenue Service. Frequently Asked Questions on Gift Taxes If the imputed interest plus any other gifts to the same person for the year stays within that amount, no gift tax return is required. Above it, the lender files Form 709, even if no tax is due, to track use of the $15,000,000 lifetime gift and estate tax exemption.14Internal Revenue Service. Whats New – Estate and Gift Tax Charging at least the AFR sidesteps all of it.
Notes Taken Back in a Property Sale
When you sell property and receive at least one payment after the end of the tax year, the sale is reported on the installment method.15Office of the Law Revision Counsel. 26 USC 453 – Installment Method Instead of taxing all the gain up front, you spread it across the years you receive payments.
The mechanics run on the gross profit ratio: total gain divided by the total contract price. That ratio, applied to each payment, tells you how much of the payment is taxable gain; the rest is a tax-free return of basis. Interest on the note is reported separately as ordinary income.16eCFR. 26 CFR 15a.453-1 – Installment Method Reporting for Sales of Real Property and Casual Sales of Personal Property
You file Form 6252 every year you have an outstanding installment obligation, even in a year you receive no payment.17Internal Revenue Service. Form 6252 – Installment Sale Income One trap: if the property carried depreciation, all of the depreciation recapture is taxed as ordinary income in the year of sale, regardless of how little cash you actually received. Only gain above the recapture amount stretches out over future payments.
Selling, Giving Away, or Inheriting a Note
Selling a promissory note to a third party before it matures is treated as the sale of a capital asset. Gain or loss equals what you receive minus your adjusted basis, which is typically the principal you lent plus any OID you have already reported. Held over a year, any gain is long-term; held one year or less, it is short-term and taxed as ordinary income. Report the sale on Form 8949 and Schedule D.
Disposing of an Installment Note
If the note came from an installment sale and you later sell it, give it away, or cancel it, you recognize gain or loss as if you had sold the underlying property.18Office of the Law Revision Counsel. 26 USC 453B – Gain or Loss on Disposition of Installment Obligations Canceling a related party’s note is treated especially strictly: the note’s fair market value is deemed to be no less than its face amount, so you cannot argue it was worth less than what was owed.
Transfers of installment obligations between spouses, or incident to divorce, carry no immediate tax consequences. The receiving spouse steps into the transferor’s position and recognizes gain as future payments come in.
Death of the Lender
If the lender dies holding the note, the heir generally receives a stepped-up basis equal to the note’s fair market value on the date of death, typically the remaining principal plus accrued unpaid interest.19Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent Any appreciation up to that point escapes income tax; the heir owes tax only on interest that accrues after inheriting the note.
Paying Interest to a Foreign Lender
A boundary that catches U.S. borrowers off guard: when interest is paid on a promissory note to a nonresident alien or foreign entity, the borrower generally must withhold 30% of each interest payment and send it to the IRS.20Internal Revenue Service. Publication 515 (2026), Withholding of Tax on Nonresident Aliens and Foreign Entities The 30% comes off the gross interest, not the net.
A tax treaty between the United States and the lender’s country may lower or eliminate the rate. The foreign lender claims that benefit by giving the borrower Form W-8BEN (individual) or W-8BEN-E (entity). Whether or not any tax was actually withheld, the borrower reports the payments on Form 1042-S, due to both the IRS and the recipient by March 15 of the following year.21Internal Revenue Service. Instructions for Form 1042-S A borrower who fails to withhold when required is personally on the hook for the tax.