Copyright

The Treatment of Loans as Income

Instructor: Yuanxin (Amy) Yang Alcocer

Amy has a master's degree in secondary education and has taught math at a public charter high school.

Did you know that sometimes a loan can become income? That's right, money that you borrowed and technically have to pay back may become income and taxable. Learn how in this lesson.

Loans

When people get a loan, a borrowed amount of money, it's because they need the money for something. They don't have the money to do what they want, like buy a house. Usually, these loans are expected to be paid back within a certain period of time. A home mortgage, for example, is a loan that covers the cost of your home. Mortgages are expected to be paid back within 30 years, 15 years, or some other agreed upon time frame. People also get loans for things like vacations or home improvement projects. When people get a loan to pay for something over time, they aren't considering it as income.

Loans are usually not considered taxable income
loans as income

When a Loan Becomes Taxable

But, there is one situation where a loan does become income and becomes taxable. This is when a loan is forgiven or canceled. When a loan is canceled or forgiven, it no longer needs to be paid back. Therefore, to the IRS, the loan has now become taxable income. This is referred to as cancellation of debt income.

There is another situation where a loan will be considered income even if the loan account is still active (it has neither been forgiven nor has it been paid back in full). In this situation, the loan may be questionable to begin with. This is what happened in Tax Court to a man named Jonathan Landow. Landow got a loan by using his securities as collateral, with the stipulation that the lender was able to sell the securities. This loan amounted to $13.5 million. Landow didn't pay back a penny of it. To the IRS, this loan was nothing more than a cover-up for a sale. So, they treated this loan as income for Landow.

Keeping a Loan Non-Taxable

So, how do people make sure that their loan remains non-taxable? They make sure that their loan is not questionable, that it is just a loan. They also make sure that their loans are not forgiven or canceled. They make sure to pay back any loan that they get.

Exemptions

If a person does have a loan that happens to be forgiven, there is an exemption they can claim to prevent this loan from turning into taxable income. The exemption, though, has stipulations that need to be met for it to be valid. For example, the loan has to be from a private lender, such as your Dad. The loan needs to be forgiven as a gift. And, if the amount forgiven is more than $13,000 in one year, it becomes part of the $1 million lifetime exemption maximum that the government allows to be exempted from the gift tax.

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