Are Loans Taxed? Forgiven Debt, Interest, and 401(k) Loans

Loans are not taxed as income. When you borrow money, the cash you receive is matched by an equal obligation to repay, so your net wealth doesn’t change and the IRS has nothing to tax. That’s true for mortgages, personal loans, student loans, business loans, credit card advances, and money borrowed from family. Tax enters the picture only later, through specific events: a lender forgives part of what you owe, you pay deductible interest, you default on a retirement plan loan, or you lend money yourself at a below-market rate. Each of those has its own rules, and that’s where the real tax questions live.

Why Borrowed Money Isn’t Income

Federal tax law defines gross income as “all income from whatever source derived,” a deliberately broad net.¹ Loan proceeds escape that net because every dollar you receive is matched by a dollar you owe. The repayment obligation offsets the cash, so there’s no accession to wealth. That’s the entire reason borrowed money isn’t income.

The moment that repayment obligation shrinks or disappears, the math changes. If a lender wipes out part of what you owe, you’re left with money you no longer have to give back. At that point the IRS has something to tax.

When Forgiven Debt Becomes Taxable

If a lender cancels, forgives, or settles a debt for less than you owe, the amount you no longer have to repay is generally treated as ordinary income. The tax code specifically lists “income from discharge of indebtedness” as a component of gross income.¹ If you owed $40,000 and your creditor accepts $25,000 as full payment, the remaining $15,000 is cancellation-of-debt income on your return.

The rule reaches widely. Credit card settlements, negotiated reductions on medical bills, forgiven personal loans, and deficiency balances wiped out after a foreclosure can all trigger it. Starting in 2026, student loan forgiveness under income-driven repayment plans is also taxable again, because the temporary exclusion under the American Rescue Plan Act applied only to discharges through December 31, 2025.²

Lenders who cancel $600 or more of debt are required to report it to the IRS on Form 1099-C.³ Even if a 1099-C never arrives in your mailbox, you still owe tax on the forgiven amount. The reporting duty belongs to the lender; the tax duty is yours.

Exclusions That Can Shield You

Congress carved out several situations where cancelled debt stays out of taxable income. Each has its own conditions and limits:⁴

Debt discharged in a Title 11 bankruptcy case is fully excluded, regardless of amount. This is the broadest exclusion.
If your total liabilities exceeded the fair market value of your total assets immediately before the cancellation, you can exclude the forgiven amount up to the degree of your insolvency. Someone insolvent by $30,000 can exclude up to $30,000 of cancelled debt.
For taxpayers other than C corporations, debt tied to real property used in a trade or business qualifies for exclusion, generally limited to the amount by which the loan exceeds the property’s fair market value.
Qualified farm indebtedness cancelled by a qualified lender can be excluded under separate rules.
Qualified principal residence indebtedness historically sheltered homeowners whose mortgage debt was reduced through modification or foreclosure. This exclusion expired for discharges after December 31, 2025, and has not been renewed.⁵

Excluding cancelled debt isn’t a free pass. In exchange for skipping tax now, you must reduce certain tax benefits you’d otherwise carry forward: net operating losses, general business and minimum tax credits, capital loss carryovers, property basis, passive activity carryovers, and foreign tax credits. The reductions follow a strict order and are reported on Form 982.⁶ The practical effect is deferral with a cost: losing a net operating loss means less shelter for next year’s income, and a lower property basis means a bigger taxable gain when you sell.

When Loan Interest Is Deductible

The interest you pay is a cost of borrowing, and whether you can deduct it depends on what you did with the money. Personal interest, including credit cards and auto loans, is flatly non-deductible.⁷ That rule catches people off guard: interest on a $30,000 car loan gives you nothing at tax time.

The main exceptions:

Mortgage Interest

Interest on a mortgage secured by your primary home or a second home is deductible if you itemize, but the deduction is capped. For loans taken out after December 15, 2017, you can deduct interest only on the first $750,000 of acquisition debt ($375,000 if married filing separately).⁷ Acquisition debt means money borrowed to buy, build, or substantially improve the home securing the loan. A home equity line used to renovate a kitchen qualifies; the same line used to pay off credit cards does not.

Student Loan Interest

You can deduct up to $2,500 per year in interest paid on a qualified education loan, without itemizing. The deduction phases out at higher income levels based on your modified adjusted gross income, and the thresholds are adjusted annually for inflation.⁸ Married borrowers must file jointly to claim it.

Business and Investment Interest

Interest on debt used to finance a trade or business is generally deductible as an ordinary business expense, though larger businesses face a cap tied to adjusted taxable income.⁹ Interest on debt used to buy taxable investments, like margin loans for stocks, is deductible up to your net investment income for the year, with any excess carrying forward indefinitely.⁷

Retirement Plan Loans Can Become Taxable

Borrowing from your 401(k) or similar employer-sponsored plan isn’t taxable, as long as you follow the rules. Break them, and the loan converts into a taxable distribution with penalties.

Federal law limits plan loans to the lesser of $50,000 or 50 percent of your vested account balance (with a floor of $10,000), and you must repay within five years through substantially equal payments made at least quarterly.¹⁰ Loans taken to buy your principal residence can stretch beyond five years.

If you miss payments or leave your job with an outstanding balance, the unpaid amount is treated as a “deemed distribution.” It’s taxed as ordinary income for the year the default occurs, and if you’re under 59½, you’ll also face an additional 10 percent early distribution tax.¹¹ Most plans offer a cure period, typically through the end of the quarter following a missed payment, to catch up before the deemed distribution kicks in.

One detail that trips people up: a deemed distribution doesn’t erase the loan. The unpaid balance stays on the books, accruing interest, until it’s actually repaid or offset against your account balance. You can owe tax on money you still technically owe back to your own retirement account.

Family and Below-Market Loans

Loans between family members, employers and employees, or corporations and their shareholders get extra IRS scrutiny. When these related-party loans charge little or no interest, the IRS doesn’t accept the terms at face value. It imputes interest: it assumes a market-rate interest payment occurred and taxes accordingly, even though no money actually changed hands.¹²

The benchmark is the Applicable Federal Rate, which the IRS publishes monthly. There are short-term, mid-term, and long-term rates corresponding to the loan’s duration.¹³ If your loan charges less than the relevant AFR, the difference is treated as a transfer from lender to borrower and then back again as interest. That phantom interest creates taxable income for the lender and, depending on the relationship, can also be treated as a gift, compensation, or dividend to the borrower.

Picture a parent lending a child $100,000 at zero interest. The IRS treats the forgone interest as a gift from parent to child, then recharacterizes it as interest income flowing back to the parent. The parent owes income tax on interest they never collected, and the gift may count against their lifetime gift tax exclusion.

There’s an important escape hatch. Loans of $10,000 or less between individuals are generally exempt from imputed interest rules, and the same $10,000 threshold applies to compensation-related and corporate-shareholder loans.¹² Above that amount, documenting a written loan agreement at or above the AFR is the simplest way to stay clear of trouble.

If You’re the Lender

The flip side matters too. If you’re the one making the loan, the interest a borrower pays you is ordinary taxable income.¹ Principal repayments are just a return of your own capital and aren’t taxed. If a borrower stops paying and the debt becomes completely worthless, you may be able to claim a bad debt deduction, treated as a short-term capital loss for personal loans and an ordinary loss for business debts. You’ll need documentation of your collection efforts and must claim the deduction in the year the debt becomes worthless.

1
Office of the Law Revision Counsel. 26 U.S. Code 61 – Gross Income Defined
2
Taxpayer Advocate Service. What to Know About Student Loan Forgiveness and Your Taxes
3
Internal Revenue Service. About Form 1099-C, Cancellation of Debt
4
Office of the Law Revision Counsel. 26 U.S. Code 108 – Income From Discharge of Indebtedness
5
Internal Revenue Service. Publication 4681 (2025), Canceled Debts, Foreclosures, Repossessions, and Abandonments
6
Internal Revenue Service. Instructions for Form 982 – Reduction of Tax Attributes Due to Discharge of Indebtedness
7
Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest
8
Internal Revenue Service. Topic No. 456, Student Loan Interest Deduction
9
Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
10
Internal Revenue Service. Retirement Plans FAQs Regarding Loans
11
eCFR. 26 CFR 1.72(p)-1 – Loans Treated as Distributions
12
Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans With Below-Market Interest Rates
13
Internal Revenue Service. Applicable Federal Rates