If you have lent money that the borrower has agreed through a promissory note to repay, and you are charging interest on that loan, you will earn interest income that, by law, you must report to the Internal Revenue Service. There are exceptions and conditions attached to this rule, but the IRS essentially considers all interest earned from loans of any kind as taxable income.
A promissory note is a signed and legal contract to repay a loan. The borrower and the lender agree to terms spelled out in the note, including the rate of interest and the repayment schedule. Some promissory notes come with "balloon" payment clauses, acceleration clauses if a payment is missed, or "on demand" conditions that allow the lender to demand repayment in full at any time. But no matter the terms, any interest earned from a promissory note is taxable income.
To report this income, the borrower who pays the interest completes a Form 1099-INT and submits one copy to the lender and one to the IRS. The form spells out the total amount of interest paid to the lender during the tax year. The IRS waives this requirement if the interest amounts to less than $10 for the year. Any party drawing interest on a personal loan, a mortgage, a savings account (which is a loan to a bank), a corporate or municipal bond, or any other investment is earning taxable income.
The IRS makes another exception for "non-business" transactions -- those carried out between individuals or private parties. If you contract a loan and sign a promissory note outside of a business or trade relationship, the interest is exempt from the Form 1099-INT reporting requirements. Exemption from this reporting does not mean the interest is tax-free for the lender. The IRS requires that any interest you earn be included in your gross income and declared on your Form 1040 tax return, even if you don't receive a Form 1099-INT. If you fail to meet this requirement, and the IRS discovers the payment of interest (through the borrower deducting the interest on his tax return, for example), the agency will recalculate your taxes and levy interest and penalties for any unpaid tax.
If you earned more than $1,500 in interest from all sources, then you must itemize this income on Schedule B. You must file Form 1040 or 1040A if this is the case; you may not file Form 1040EZ. The IRS also requires Schedule B if you earned interest from the sale of your home which you financed, no matter how much interest the borrower paid. Most privately financed mortgages are conducted through promissory notes, since there is no approval process for the loan and minimal regulation of promissory contracts.
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