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.
You must report interest you collect on a personal loan and pay tax on it. If you collect less than market rate interest on a loan greater than $10,000 you must still pay tax on the foregone interest and may owe gift tax.
Personal Loan Income Tax
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 you collect must be included on your tax return. The loan interest income tax rate is just your ordinary income rate, just like the tax on bank interest or salary.
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. You are also considered to have given a gift to the person in the form of the foregone interest, and this gift may be taxable if it's above your gift tax exclusion and reportable if it's greater than the annual gift tax exclusion.
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 federal rate.
Most taxpayers report income under the cash method of accounting, meaning interest is reported in the tax year payment is received. 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.
Loan interest income taxable by the federal government 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.
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.
2018 Tax Law
As of 2018, the annual gift tax exclusion is $15,000 per giver and recipient and lifetime total limit before gift tax kicks in is $11.2 million. It's unlikely that you'll exceed that with foregone interest on any loan, but if you make other gifts to the same person you may get near the limit.
2017 Tax Law
As of 2017, the gift tax limits were still reasonably high. The annual exclusion was $14,000 and the lifetime exclusion was $5.49 million for a single taxpayer.
Michael Marz has worked in the financial sector since 2002, specializing in wealth and estate planning. After spending six years working for a large investment bank and an accounting firm, Marz is now self-employed as a consultant, focusing on complex estate and gift tax compliance and planning.