What Are the Tax Implications of a Loan From a Friend?

Borrowing money from a friend doesn’t create taxable income, but the tax implications of a loan from a friend reach further than most people expect. The IRS can recharacterize a sloppy loan as a gift, impute interest the lender never collected, tax any forgiven balance as income to the borrower, and deny deductions the borrower assumed were automatic. How you document the arrangement and what interest rate you charge decide most of what follows.

The Money Itself Isn’t Income

Cash you borrow isn’t gross income, because the obligation to repay offsets the cash coming in. Your net wealth hasn’t changed. That rule holds whether the lender is a bank, a credit card issuer, or your college roommate. The tax picture only shifts if the IRS decides the arrangement was never a real loan, or if the lender later releases you from paying it back.

Keeping the IRS From Calling It a Gift

Hand a friend $50,000 with no paperwork, no interest, and no serious plan to collect, and the IRS will treat the transfer as a gift. That matters because gifts above the annual exclusion require the giver to file Form 709 and consume part of the lifetime gift and estate tax exemption.¹ The agency looks at the substance of the transaction, not its label. A note shoved in a drawer that nobody enforces won’t support a debtor-creditor relationship.

Courts weigh several factors in deciding whether a transfer between friends is really a loan: a signed promissory note, a reasonable interest rate, payments actually made on schedule, the lender’s right to enforce collection, and the borrower treating the obligation as real debt. No single factor controls, but each one you can check off strengthens your position.

What the Promissory Note Should Say

A written promissory note is the single strongest piece of evidence that a true loan exists. It doesn’t need to be notarized to be valid, though notarization helps if enforcement ever becomes necessary. At minimum, the note should spell out:

The principal amount being lent.
The interest rate, stated explicitly even if set at zero. Charging at least the Applicable Federal Rate avoids the imputed interest problem discussed below.
A repayment schedule, whether fixed monthly payments, a lump-sum maturity date, or another defined plan.
Default terms, including late fees and the lender’s right to pursue collection.
Both signatures, dated before the money changes hands.

Collateral helps too. If the borrower pledges a car or equipment, the lender can file a UCC-1 financing statement with the state to perfect the security interest. If the loan is secured by real estate, a recorded mortgage or deed of trust does the same job. These steps move the arrangement well beyond anything the IRS would characterize as a casual gift.

If It Does Get Treated as a Gift

The annual gift tax exclusion for 2026 is $19,000 per recipient. A married couple electing gift-splitting can effectively exclude $38,000 per recipient.² Anything above that requires the lender to file Form 709 for the year the gift occurred.³

Filing Form 709 doesn’t mean you owe gift tax. The excess reduces the lifetime gift and estate tax exemption, which for 2026 is $15 million per person. No actual gift tax is due until cumulative lifetime gifts above the annual exclusion eat through that entire exemption. For most people lending money to a friend, the real risk is paperwork rather than a tax bill. Failing to file when required can bring penalties and keeps the statute of limitations open indefinitely.

Imputed Interest and the Applicable Federal Rate

Even when the IRS accepts the arrangement as a real loan, charging too little interest creates a separate problem. Under the below-market loan rules, if you lend at a rate lower than the Applicable Federal Rate, the IRS imputes the difference as if the lender had received it.⁴ That phantom income is taxable to the lender even though no cash changed hands. The forgone interest can also be treated as a gift from the lender to the borrower.

The AFR is published monthly and varies by loan term:⁵

Short-term, for loans of three years or less.
Mid-term, for loans over three years and up to nine years.
Long-term, for loans over nine years.

Those breakpoints come from the statute that governs how the rates are set.⁶ As a reference point, the short-term AFR in late 2025 was around 3.66%, the mid-term rate about 3.79%, and the long-term rate approximately 4.55%. The rates change monthly, so check the IRS page before finalizing terms.

If the note is written as “payable on demand” rather than with a fixed maturity, the IRS treats it as a demand loan and calculates imputed interest annually on the last day of each calendar year. For term loans, the entire gift element is calculated upfront as the difference between the amount lent and the present value of the required payments discounted at the AFR.⁷

Safe Harbors for Smaller Loans

Two statutory exceptions spare smaller loans from most of this.

If the total outstanding balance between you and the borrower stays at or below $10,000, the below-market loan rules don’t apply at all. Charge whatever rate you want, including zero, and nothing gets imputed. The exception disappears if a main purpose of the arrangement is tax avoidance.⁴

For gift loans with a balance at or under $100,000, the interest the lender must report is capped at the borrower’s net investment income for the year. If that net investment income is $1,000 or less, the IRS treats it as zero and nothing is imputed.⁸ Tax avoidance again cannot be a main purpose. Once the balance crosses $100,000, the full rules apply with no cap.⁴

Because the $100,000 exception requires tracking the borrower’s net investment income, many lenders find it easier to just charge the AFR. At current rates the cost to the borrower is modest, and the complication goes away.

What the Lender Owes and Reports

Interest the lender actually receives, or has imputed under the below-market rules, is ordinary income. It gets reported on Schedule B of Form 1040, the same way interest from a savings account would.⁹

A common misconception is that the lender must issue a Form 1099-INT to the borrower. For a personal loan between individuals, that’s generally not required. The IRS instructions exclude interest on obligations issued by individuals from the 1099-INT reporting requirement.¹⁰ The lender still owes tax on the interest regardless.

If the Loan Goes Bad

When a borrower stops paying and the debt becomes completely worthless, the lender may be able to claim a nonbusiness bad debt deduction. To qualify, the lender must show a genuine loan existed (not a gift), that reasonable collection efforts were made, and that there’s no realistic prospect of repayment.¹¹

The debt has to be totally worthless. A partially unpaid personal loan doesn’t qualify. Typical evidence includes the borrower’s bankruptcy filing, a documented inability to locate them, or repeated failed collection attempts. The IRS requires a detailed statement attached to the return describing the debt, the debtor, your collection efforts, and why you concluded the debt was worthless.¹¹

A nonbusiness bad debt is always treated as a short-term capital loss, regardless of how long the loan was outstanding. You report it on Form 8949 and Schedule D. It first offsets any capital gains you have for the year. Any remaining net capital loss can offset up to $3,000 of ordinary income per year ($1,500 if married filing separately), with the excess carried forward.¹² For a large bad loan, the annual cap means it can take years to fully deduct the loss.

The catch: if you handed over the money understanding your friend might never repay it, the IRS treats the transfer as a gift from day one, and no bad debt deduction is available. That’s where the promissory note and documented collection efforts prove their value.

What the Borrower Owes and Reports

The Interest Isn’t Deductible

Interest paid on a personal loan from a friend is classified as personal interest and is not deductible on your federal return.¹³ It doesn’t matter whether you paid the AFR, more, or less. Unless the loan qualifies as home mortgage debt or was used for business or investment, the interest is simply a nondeductible personal expense.

Forgiven Debt Is Income

The larger tax risk for the borrower comes when the lender writes off part or all of the balance. Forgiven debt is generally cancellation-of-debt income, which the IRS treats as ordinary income because your net wealth went up when the obligation disappeared.¹⁴ If a friend lends you $30,000 and later says to forget the last $15,000, that $15,000 is taxable income for the year of forgiveness.

When a financial institution cancels $600 or more of debt, it files Form 1099-C with the IRS and sends a copy to the borrower.¹⁵ A friend isn’t required to file 1099-C, because the obligation applies only to certain financial entities. The absence of a form doesn’t erase the income though. You’re still required to report it.

Several exclusions can keep forgiven debt from being taxed:

Insolvency. If your total liabilities exceeded your total assets immediately before the cancellation, you can exclude the forgiven amount up to the extent of your insolvency.
Bankruptcy. Debt discharged while you’re under the jurisdiction of a bankruptcy court is fully excluded.
Gift treatment. If the lender forgave the debt out of generosity rather than settling a dispute, the forgiven amount isn’t income to you. The lender takes on any gift tax consequences instead.

Insolvency and bankruptcy exclusions usually require filing Form 982 and reducing certain tax attributes.¹⁶ The gift route is simpler for the borrower but shifts reporting to the lender, who may need to file Form 709 if the forgiven amount exceeds the annual exclusion.

If the Loan Pays for a Home

When your friend lends you money to buy a home and the loan is secured by a recorded mortgage or deed of trust on the property, the interest you pay may qualify for the home mortgage interest deduction. The loan must be secured debt on a qualified home, you must itemize on Schedule A, and both parties must intend repayment.¹⁷ An unsecured personal loan used for a home purchase doesn’t qualify, even if every dollar went to the price.

A friend who receives mortgage interest generally isn’t required to file Form 1098 unless the interest was received in the course of a trade or business. The IRS gives the example of a physician lending money for a personal home sale: no reporting required, because the interest wasn’t received as part of the physician’s business.¹⁸ The borrower can still claim the deduction by reporting the lender’s name, address, and taxpayer identification number directly on Schedule A.

State Usury Caps

Every state has usury laws that limit the interest rate a private lender can charge. Ceilings range from as low as 6% in some states to 30% or higher in others, with many states carving out exceptions for business or commercial loans. Charging over the legal limit can void the interest portion of the loan and, in some states, expose the lender to penalties. If you’re setting a rate above the AFR, check your state’s cap first. For most friend-to-friend loans, charging the AFR stays well inside usury limits everywhere and resolves the imputed interest question in the same move.

1
Internal Revenue Service. Instructions for Form 709 (2025)
2
Internal Revenue Service. Frequently Asked Questions on Gift Taxes
3
Internal Revenue Service. What’s New – Estate and Gift Tax
4
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
5
Internal Revenue Service. Applicable Federal Rates
6
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
7
GovInfo. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
8
Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses
9
Internal Revenue Service. 2025 Schedule B (Form 1040) – Interest and Ordinary Dividends
10
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID (01/2024)
11
Internal Revenue Service. Topic No. 453, Bad Debt Deduction
12
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
13
Internal Revenue Service. Topic No. 505, Interest Expense
14
Internal Revenue Service. Topic No. 431, Canceled Debt – Is It Taxable or Not?
15
Internal Revenue Service. Instructions for Forms 1099-A and 1099-C (Rev. April 2025)
16
Internal Revenue Service. About Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)
17
Internal Revenue Service. Publication 936 (2025), Home Mortgage Interest Deduction
18
Internal Revenue Service. Instructions for Form 1098