The tax laws are written in such a way so that virtually every dollar you earn is taxable unless a specific exception exists. Interest collected on a personal loan you make, unfortunately, has no such exception. In fact, when you lend a friend or family member money, you might even have to report more interest than you actually collect on your tax return.
Taxable Loan Interest
As long as you're not in the personal-loan business, it doesn't matter whether you make the loan with the intention of earning some interest income or as a favor to a friend or family member in need – every dollar of interest you collect must be included on your tax return. The interest is taxed as ordinary income, which is how most other income, such as your salary and self-employment earnings, is taxed.
Below-Market Interest Loans
If your reason for making the personal loan is mainly to help someone out, the Internal Revenue Service treats it as a gift loan. When the interest rate charged on a gift loan is less than the market interest rate – meaning banks and other financial institutions would charge higher rates of interest on the same loan – the below-market interest loan rules apply, and the IRS will require you to include “foregone interest” on your return. Foregone interest is the difference between the actual interest rate you charge and the applicable federal interest rate. In other words, regardless of the interest you collect, the minimum you'll have to pay tax on is the amount you would've collected had you charged the applicable federal interest rate instead.
The below-market rules will not apply at any time the outstanding loan balance is $10,000 or less, provided the borrower doesn't use the funds to purchase income-producing property, such as investments. For example, if you lend your sister $9,000 to purchase a car, the below-market rules don't apply to the loan. But if she buys stocks instead, you'll need to report the foregone interest on your return.
When To Report
Most taxpayers report income under the cash method of accounting, meaning interest is reported in the tax year payment is received. So if you're a cash basis taxpayer, you'll report the interest in the year it's collected. If you happen to file your taxes under the accrual method, you report the interest in the year payment is due – even if the borrower's payments are late and made in a different tax year.
How To Report
Interest from a personal loan is always reported on the “Taxable interest” line of your return. But if your total interest income for the year – not just the interest collected on the loan – is more than $1,500, you'll need to report it on a Schedule B attachment to your return. Schedule B just requires some of the details surrounding your interest earnings. For the personal loan, this means you'll need to enter the borrower's name and the total amount of interest you collected from him.