The tax implications of a loan from a friend fall into a few predictable buckets: the money you receive isn’t taxable income, but the IRS can reclassify a sloppy arrangement as a gift, impute interest to the lender if the rate is too low, and treat any forgiven balance as taxable income to the borrower. How the loan is documented, what interest rate is charged, and what happens if repayment stalls all determine who owes what.
Borrowed Money Isn’t Income
Cash you borrow doesn’t count as gross income because you have an obligation to repay it. The money comes in, but a matching liability comes with it, so your net wealth hasn’t changed. That’s true whether the lender is a bank, a credit card issuer, or a college roommate. The tax picture only shifts when the loan falls apart, either because the IRS decides it was never a real loan or because the lender later forgives the balance.
When the IRS Calls It a Gift Instead
Hand someone $50,000 with no written terms, no interest rate, and no plan to collect, and the IRS will treat that transfer as a gift. The distinction matters: gifts above the annual exclusion require the giver to file Form 709 and count against the lifetime gift and estate tax exemption.1Internal Revenue Service. Instructions for Form 709 (2025) The agency looks at what actually happened, not what the parties call it. A note in a drawer that nobody enforces will not convince anyone a real debtor-creditor relationship existed.
The annual gift tax exclusion for 2026 is $19,000 per recipient. Married couples electing gift-splitting can exclude up to $38,000 per recipient.2Internal Revenue Service. Frequently Asked Questions on Gift Taxes Anything above that requires the lender to file Form 709 for the year the gift is deemed to have occurred.3Internal Revenue Service. What’s New – Estate and Gift Tax
Filing Form 709 doesn’t mean you owe gift tax. The excess reduces your lifetime exemption, which for 2026 is $15 million per person. You don’t owe a dollar of gift tax until cumulative lifetime gifts above the annual exclusion eat through the entire exemption. For most people, the practical risk is paperwork, not a tax bill. But the paperwork matters. Failing to file Form 709 when required can produce penalties and keep the statute of limitations open indefinitely.
Documenting the Loan
A written promissory note is the single most important piece of evidence that a genuine loan exists. It doesn’t need to be notarized to be legally valid, though notarization helps if enforcement ever becomes necessary. At minimum the note should state:
- The principal amount being lent.
- The interest rate, stated explicitly even if set at zero. Charging at least the Applicable Federal Rate avoids imputed interest problems, covered below.
- A repayment schedule: fixed monthly payments, a lump-sum maturity date, or another clearly defined plan.
- Default terms, including any late fees and the lender’s right to pursue collection.
- Both parties’ signatures and the date, before the money changes hands.
Collateral strengthens the arrangement further. If the borrower pledges a car or other personal property, the lender can file a UCC-1 financing statement with the state to perfect the security interest. Real estate collateral gets the same effect through a recorded mortgage or deed of trust. And the loan actually needs to look like one in practice: payments made on schedule, the lender enforcing missed payments, the borrower treating the obligation as a real debt.
The Interest Rate Problem
Even when the IRS accepts the arrangement as a real loan, charging too little interest creates its own tax issue. Under the below-market loan rules, if you lend at a rate lower than the Applicable Federal Rate, the IRS imputes the difference as though the lender received it.4Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates That phantom interest is taxable to the lender even though no cash actually changed hands. The forgone interest may also be treated as a gift from lender to borrower.
The AFR is published monthly by the IRS and comes in three tiers based on loan term:5Internal Revenue Service. Applicable Federal Rates
- Short-term, for loans of three years or less.
- Mid-term, for loans over three years but not more than nine years.
- Long-term, for loans over nine years.
As a rough reference point, the short-term AFR in late 2025 ran around 3.66%, the mid-term rate around 3.79%, and the long-term rate around 4.55%. Because the rates shift monthly, check the current IRS page before finalizing the note.
Two Safe Harbors for Smaller Loans
If the total outstanding balance between you and the borrower stays at or below $10,000, the below-market loan rules don’t apply at all. You can charge zero and the IRS won’t impute anything. The exception disappears if tax avoidance is one of the main purposes of the arrangement.4Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
For gift loans where the outstanding balance stays at or under $100,000, the imputed interest the lender must report is capped at the borrower’s net investment income for the year. If that net investment income is $1,000 or less, the IRS treats it as zero, so no interest is imputed.6Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses This exception also requires that tax avoidance not be a main purpose. Above $100,000, the full imputed interest rules apply with no cap.
Tracking someone else’s investment income is a nuisance. Many lenders simply charge the AFR and stop worrying about the issue. At current rates the cost to the borrower is modest.
What the Lender Owes Tax On
Any interest the lender receives, whether paid in cash or imputed under the below-market rules, is ordinary income. Report it on Schedule B of Form 1040, the same as interest from a savings account.7Internal Revenue Service. 2025 Schedule B (Form 1040) – Interest and Ordinary Dividends A common misconception is that the lender must issue Form 1099-INT to the borrower. For a personal loan between individuals, that’s generally not required.8Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID (01/2024) The tax on the interest still applies.
If the Borrower Doesn’t Pay
If the borrower stops paying and the debt becomes completely worthless, the lender may deduct the loss as a nonbusiness bad debt. This is one of the practical reasons to formalize a loan on paper. To qualify, the lender has to show three things: a genuine loan existed, reasonable collection efforts were made, and there’s no realistic expectation of repayment.9Internal Revenue Service. Topic No. 453, Bad Debt Deduction
The debt must be totally worthless. Partial nonpayment on a personal loan isn’t deductible. Typical evidence of worthlessness includes the borrower filing bankruptcy, inability to locate them, or repeated failed collection attempts. The IRS requires a detailed statement attached to the return describing the debt, the debtor, the collection efforts, and the basis for treating the debt as worthless.9Internal Revenue Service. Topic No. 453, Bad Debt Deduction
A nonbusiness bad debt is always treated as a short-term capital loss, regardless of how long the loan was outstanding. Report it on Form 8949 and Schedule D. The loss first offsets any capital gains. Any remaining net capital loss can offset up to $3,000 of ordinary income ($1,500 if married filing separately), with the excess carried forward.10Internal Revenue Service. Topic No. 409, Capital Gains and Losses For a large unpaid loan, that annual cap means it can take years to fully deduct.
Here’s the catch. If you lent the money understanding your friend might not repay, the IRS considers the transfer a gift from day one, and no bad debt deduction is available. This is where the promissory note and documented collection efforts earn their keep.
What the Borrower Owes Tax On
Interest paid on a personal loan from a friend is personal interest and isn’t deductible on your federal return.11Internal Revenue Service. Topic No. 505, Interest Expense Paying the AFR, a higher rate, or something in between doesn’t change that. Unless the loan qualifies as home mortgage debt or funds a business or investment, the interest is a nondeductible personal expense.
Forgiven Debt Becomes Income
The bigger tax risk for the borrower shows up when the lender forgives all or part of the outstanding balance. Forgiven debt is generally cancellation-of-debt income, which the IRS treats as ordinary income because the borrower’s net wealth increased when the repayment obligation vanished.12Internal Revenue Service. Topic No. 431, Canceled Debt – Is It Taxable or Not? If a friend lends you $30,000 and later tells you to forget about the last $15,000, that $15,000 becomes taxable income for the year of forgiveness.
Financial institutions that cancel $600 or more of debt file Form 1099-C.13Internal Revenue Service. Instructions for Forms 1099-A and 1099-C (Rev. April 2025) A friend isn’t required to. The absence of a 1099-C doesn’t erase the income; the borrower is still legally required to report the forgiven amount.
Several exclusions can protect the borrower from tax on forgiven debt:
- Insolvency. If your total liabilities exceeded your total assets immediately before cancellation, you can exclude the forgiven amount up to the extent of your insolvency.
- Bankruptcy. Debt discharged under a bankruptcy court’s jurisdiction is fully excluded.
- Gift treatment. If the lender forgave the debt as a gift rather than settling a dispute, the forgiven amount isn’t income to you. The lender bears any gift tax consequences instead.
Insolvency and bankruptcy exclusions typically require filing Form 982, which also reduces certain tax attributes like loss carryforwards or asset basis.14Internal Revenue Service. About Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) The gift route is simpler for the borrower but shifts the paperwork burden to the lender, who may need to file Form 709 if the forgiven amount exceeds the annual exclusion.
When a Home Purchase Is Involved
If your friend lends you money to buy a home and the loan is secured by a recorded mortgage or deed of trust on the property, the interest you pay may qualify for the home mortgage interest deduction. To claim it, the loan must be secured debt on a qualified home, you must itemize on Schedule A, and both parties must intend that the loan be repaid.15Internal Revenue Service. Publication 936 (2025), Home Mortgage Interest Deduction An unsecured personal loan used to buy a house doesn’t qualify, even if every dollar went to the purchase price.
A friend receiving mortgage interest isn’t generally required to file Form 1098 unless the interest was received in the course of a trade or business.16Internal Revenue Service. Instructions for Form 1098 The borrower can still claim the deduction by reporting the lender’s name, address, and taxpayer identification number directly on Schedule A.
State Usury Caps
Every state caps the interest rate a private lender can charge. Ceilings vary widely, from as low as 6% in some states to 30% or higher in others, with common carveouts for business or commercial loans. Charging above the legal limit can void the interest portion of the loan and, in some states, expose the lender to penalties. If you’re setting a rate above the AFR, check your state’s limits first. For most friend-to-friend loans, charging the AFR stays well within usury caps everywhere and solves the imputed interest question at the same time.