Do You Have to Pay Taxes on a Loan or Forgiven Debt?

You do not have to pay taxes on a loan when you receive the money. Borrowing does not increase your net worth — the cash you get is matched by an equal obligation to repay it — so federal tax law does not treat loan proceeds as income.¹ That is true whether you take out a mortgage, an auto loan, a student loan, a personal loan, or a business line of credit. Taxes come into the picture later, and only in specific situations: when a lender forgives part of what you owe, when the interest rate is below market, or when a retirement plan loan defaults.

Why Borrowed Money Isn’t Taxable Income

The IRS taxes increases in your net worth. When you take out a $30,000 auto loan or a $400,000 mortgage, cash lands in your account, but a matching debt lands on your balance sheet the same day. Nothing has grown, so nothing is taxed.¹

For that treatment to hold, the money has to be a real loan and not disguised income or a gift. The IRS looks for the ordinary features of a debtor-creditor relationship: a written promissory note, a fixed repayment schedule, a stated interest rate, and a maturity date.² If a parent hands an adult child $50,000 with no paperwork and no expectation of repayment, the IRS can recharacterize the transfer as a taxable gift or as compensation. A signed note and a record of regular payments is the simplest way to protect the non-taxable status of any loan, especially one between family members or between a business owner and their company.

When Forgiven Debt Becomes Taxable

The moment a lender cancels part of what you owe, the equation changes. The debt goes away, your net worth actually rises, and federal law lists discharge of indebtedness as gross income.³ If a creditor writes off a $10,000 balance, you generally report $10,000 as income for the year the write-off occurs.

A lender that cancels $600 or more of debt is required to file Form 1099-C and send you a copy.⁴ You are legally required to report the canceled amount even if the 1099-C never arrives, whether because the amount is under $600 or the lender simply fails to file it.

Canceled debt is taxed at ordinary income rates, which for 2026 range from 10% to 37% depending on your total taxable income.⁵ Someone in the 22% bracket with $15,000 forgiven could owe roughly $3,300 in additional federal tax. Leaving the amount off your return exposes you to a failure-to-pay penalty of 0.5% of the unpaid tax per month, up to 25%, plus interest.⁶

Ways to Avoid Tax on Canceled Debt

Federal law carves out several exclusions that can shrink or wipe out the taxable amount, each with its own rules.⁷ You claim any of them by attaching Form 982 to your return.

Bankruptcy

Debt canceled through a Title 11 bankruptcy case — Chapter 7, Chapter 11, or Chapter 13 — is fully excluded from income.⁸ The cancellation has to come from the court itself or from a court-approved plan, and you have to be the debtor in that case.

Insolvency

If your total liabilities exceeded the fair market value of everything you owned immediately before the cancellation, you can exclude the forgiven amount up to the size of that shortfall.⁷ Say your debts topped your assets by $3,000 and a creditor forgave $5,000. You could exclude $3,000 and would owe tax on the remaining $2,000.⁸ The insolvency calculation counts all liabilities against the fair market value of everything you own, including retirement accounts.

Forgiven Mortgage Debt

Homeowners could formerly exclude up to $750,000 of forgiven mortgage debt on a primary residence, but that exclusion expired on December 31, 2025.⁸ For a short sale, loan modification, or foreclosure settlement in 2026 or later, the forgiven balance is generally taxable unless bankruptcy or insolvency applies.

Zero-Interest and Below-Market Loans

A loan that charges no interest, or interest below the IRS’s Applicable Federal Rate, triggers a separate set of rules.⁹ The IRS calculates the difference between the rate charged and the federal rate, then treats that difference as if money changed hands even though no extra cash actually moved. What that phantom interest counts as depends on who is lending to whom.

On an employer-to-employee loan, the forgone interest is treated as additional wages. A $100,000 interest-free loan from an employer produces taxable compensation to the employee equal to the imputed interest. The statute exempts these amounts from standard income tax withholding, but the employee still reports them as income on their return.⁹

On a family loan, the forgone interest is treated as a gift from the lender to the borrower. If a parent lends $200,000 at 0% while the mid-term federal rate sits near 4%, roughly $8,000 of imputed interest per year counts as a gift. For 2026, the annual gift tax exclusion is $19,000 per recipient, so imputed interest below that threshold generally does not create a gift tax filing requirement.¹⁰

Loans of $10,000 or less between individuals are generally exempt from these imputed interest rules, as long as the borrowed money is not used to buy income-producing assets. Setting the interest rate at or above the AFR published for the month the loan is made avoids the rules entirely.

Retirement Plan Loans

Many 401(k) and similar plans let you borrow against your own account balance. A properly maintained plan loan is not a taxable event, since you are borrowing from yourself and paying yourself back with interest. Two limits apply: you cannot borrow more than 50% of your vested balance, and the total loan cannot exceed $50,000, reduced by the highest outstanding balance during the prior year on any previous loan.¹¹

The tax problem shows up if you stop paying. Miss enough installments to blow through the plan’s cure period, and the outstanding balance is treated as a deemed distribution — essentially a withdrawal from your retirement account.¹² You owe ordinary income tax on the unpaid balance, and if you are under 59½, you generally owe an additional 10% early-distribution penalty on top.

The same issue comes up when you leave a job with a plan loan still open. If the plan offsets your account to close out the loan, you can avoid the tax hit by rolling the unpaid amount into an IRA. When the offset happens because you left the employer or the plan terminated, you have until your tax filing deadline (including extensions) for that year to complete the rollover.¹³ Any other plan loan offset falls under the standard 60-day rollover window. Miss either deadline and the distribution is fully taxable.

Student Loan Forgiveness in 2026

Student loan forgiveness got significantly more expensive at the start of 2026. The American Rescue Plan Act of 2021 temporarily excluded all discharged student loan debt from federal income tax, and that provision expired on December 31, 2025.⁸ Starting in 2026, most forgiven student loan debt is again taxable ordinary income under the standard cancellation-of-debt rules.

Two permanent exceptions still apply. Service-based forgiveness, including Public Service Loan Forgiveness and other programs that discharge loans for working a qualifying period in a specific profession or for a qualifying employer, remains excluded from gross income with no expiration date.⁷ Loans discharged because of the borrower’s death or total and permanent disability may also remain nontaxable after 2025, provided the borrower has a Social Security number on file.⁸

The change bites hardest on income-driven repayment. Any balance remaining after 20 or 25 years of qualifying payments is forgiven, and that forgiveness was tax-free while ARPA was in effect. Now, a borrower with $40,000 forgiven at the end of a repayment cycle will owe federal income tax on that amount. If you are approaching the finish line on an income-driven plan, budget for the tax bill or check whether the insolvency exclusion might cover it.

Deducting Interest You Pay

Loan proceeds are not income, but the interest you pay on certain loans can lower your tax bill if you itemize or qualify for a specific above-the-line deduction.

Mortgage Interest

You can deduct interest on up to $750,000 of mortgage debt ($375,000 if married filing separately) used to buy, build, or substantially improve your primary or second home.¹⁴ Mortgages that originated on or before December 15, 2017 keep the older $1 million limit ($500,000 if filing separately). The $750,000 cap was made permanent by the One, Big, Beautiful Bill enacted in 2025. You have to itemize on Schedule A — the deduction is not available if you take the standard deduction.

Investment Interest

Interest on money borrowed to buy taxable investments, such as stocks or bonds held outside a retirement account, is deductible up to your net investment income for the year.¹⁵ Anything over that limit carries forward to the next year. Interest on loans used for personal expenses, including credit card balances and car loans, is not deductible.

1
Internal Revenue Service. Topic No. 432, Form 1099-A and Form 1099-C, Cancellation of Debt
2
Internal Revenue Service. Action on Decision 2017-04, Scott Singer Installations, Inc. v. Commissioner
3
Office of the Law Revision Counsel. 26 USC 61 – Gross Income Defined
4
Internal Revenue Service. About Form 1099-C, Cancellation of Debt
5
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
6
Internal Revenue Service. Failure to Pay Penalty
7
Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness
8
Internal Revenue Service. Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments
9
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
10
Internal Revenue Service. Frequently Asked Questions on Gift Taxes
11
Internal Revenue Service. 401(k) Plan Fix-It Guide – Participant Loans
12
Internal Revenue Service. Deemed Distributions – Participant Loans
13
eCFR. 26 CFR 1.402(c)-2 – Eligible Rollover Distributions
14
Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
15
Internal Revenue Service. Form 4952 – Investment Interest Expense Deduction