Lending money to a friend or family member is a generous gesture. Lending $50 or $100 isn’t going to get you noticed by tax officials, even if you are repaid with interest. Neither will lending $5,000. But if your loan to family or friends is above $10,000, take the time to consider the implications of personal-loan taxes. If you don’t, you are likely to get in trouble with the Internal Revenue Service. To avoid tax troubles, unless you’re giving what the IRS calls gifts, you will be taxed for the income generated from an interest rate that is at least equal to the IRS-approved applicable federal rate. If you don’t charge that interest, you’ll be expected to pay tax on the personal-loan interest anyway.
Is There a Tax on Personal Loan Interest?
There is a tax on personal-loan interest. If you’re lending money to an adult son or daughter to buy a house, pay off a mortgage or buy a new car, or anything else above $10,000 for that matter, this is the kind of loan the IRS will expect you to list on your tax return. You will need to report the income generated from the interest you are expected to charge. The same goes if you’re lending any amount of money over $10,000 to another family member or a friend. This interest rate must be at minimum the applicable federal rate or AFR. As of 2018, that interest rate is pretty low, although it changes each month. The rates have been in the 2-to-3 percent range for several years.
If you are in a position to lend $500,000 to an adult child, for example, then you’ll need to charge interest. For tax purposes, the interest the IRS expects you to charge is well below typical market interest rates. You will then declare that interest as income on your taxes. And you can't make it an abnormally low rate. There is a minimum the IRS allows you to charge, which is known as the applicable federal rate or AFR. The IRS has no problem with you charging more than the AFR. If you do, however, you’ll need to declare as income whatever interest amount you charge. If you charge less than the AFR or no interest, you’ll still need to declare the AFR amount as income. The AFR rates are much lower than a borrower could get from a bank, so by charging an AFR, you’re still doing the borrower a favor.
When you make the loan, you should draw up a contract showing the total loan amount, when it will be paid back, the rate of interest and any collateral or security. Both parties should sign the note, and each keeps a copy in a safe place. Also, if real estate is involved, you may want to use a lawyer. Many companies also handle family mortgages. If you secure the borrower’s interest on a home, that mortgage interest is tax deductible, up to $750,000. If you’re making a student loan to your child, it would be treated like any other student loan, and your child could take a student-loan interest deduction.
How to Report Personal Loan Interest Income
To accurately report personal loan interest, you'll have to get the details right when you're drawing up the terms of the loan. To figure out your AFR, you’ll need those terms. The AFR changes each month, but you can go to the AFR page on the IRS website and find the rate. In September 2018, the annual rate for short-term interest was 2.51 percent. For mid-term, it was 2.86 percent and for long-term, it was 3.02 percent. The rate was only slightly lower for semi-annual, quarterly or monthly interest. These rates are calculated based on market yields.
For short-term yields, the market yields are calculated from maturities or loan payoffs, of three years or less. For mid-term yields, the market yields are figured based on loan maturities of three-to-nine years, while for long-term rates, the market yields are figured from loan maturities of over nine years. Nearly all of these interest rates are near or below 3 percent, from monthly to annually. You decide whether the borrower should pay you once a month, quarterly, twice a year or once a year. That should also factor into the interest rate you decide to charge. All this needs to be set up when the loan is made, to make it easier for everyone involved.
You will also need to decide if the loan is a term loan or a demand loan. A term loan has specific repayment dates, and it locks in the AFR. The demand loan is only best if you expect interest rates to drop considerably during the life of the loan. In a demand loan, the AFR is a floating rate, based on fluctuating AFRs. This will make calculating your taxes more difficult and may cause the borrower some anxiety if AFRs increase.
Remember, if you're wondering are personal loans taxable, the loan itself isn’t taxable. So if your child has borrowed $500,000 over 10 years, and repays the loan at $50,000 per year, plus interest, you aren't declaring the original loan amount on your taxes. The $50,000 you are repaid each year is not considered income. But any money you give your child, including interest, will go toward your child’s annual gift cap, which is $15,000 per person.
If you lend money to a family member or friend who is using the money to buy investment property or stocks, you’ll need to be paid interest on the entire amount, even if it's under $10,000. Again, the IRS expects you to charge at least the AFR. You can’t just call your loan a gift, particularly if it's used to make investments.
The IRS has strict rules about how much money you can give away. You can give up to $15,000 per person each year. But if that money is being repaid, it’s not a gift; it’s a loan. Then you’ll need to declare at least the APR interest rate if the loan is for more than $10,000. Also, if money is paid directly to an educational or medical institution, it’s not a gift, and that money will be subject to personal-loan interest tax.
When you have lent money to a family member or a friend, and that person can’t pay their debt, having that loan contract will help you. You can then deduct the amount you should have been repaid as a non-business bad debt. One advantage to the borrower is that an unpaid debt owed to a friend or family member is unlikely to damage their credit report because such loans aren’t reported to the three major credit bureaus.
To report personal loan interest earnings on your tax return, you’ll need to report that on the taxable interest line. If you have earned more than $1,500 in all forms of interest, not just from the loan, you’ll have to fill out Schedule B. For this, you will need to report the borrower’s name, and the total amount of interest the borrower has paid, or, in the case of interest that you forgave, the AFR. To fill out the gift tax, you’ll need to file Form 709.
Exceptions to the Rules
There is no rule preventing you from paying the interest yourself. But that does make things a little more complicated. If you are going to pay some or all of the AFR interest, you’ll still need to report the interest. If you do that, the interest is then called foregone interest. You can consider that a gift, but the IRS won’t allow you to give more than $15,000 a year to an individual, and foregone interest counts toward that. For any interest you pay for the borrower over the $15,000 annual limit, you can expect to pay taxes on it because it’s still considered income.
If you want to gift up to $15,000 of the loan you’re making, you can count that toward the total you don’t need to declare. You can double that if you’re also giving money to your child’s spouse, and double that again if your spouse wants to make the same loan, for a maximum gift of $60,000. Instead of gifting part of the loan, you could gift up to the $60,000 limit for interest purposes. But don’t go above that $60,000 total. Also, as stated above, you don’t need to report the interest if the loan is for $10,000 or less unless that money is used to invest in property or the stock market.
Here’s another exception, although this one's more complicated. If you are lending someone less than $100,000, the interest you are expected to charge according to the IRS is limited to the borrower’s net investment income for the year. And if that net investment income is $1,000 or less, this will be considered foregone interest, and you do not have to pay tax on this interest. Most tax experts recommend, however, that you charge at least the AFR and report that income.
Your 2018 Taxes
For 2018, the rules haven’t changed as far as personal-loan income tax. You’ll still have to charge at least the AFR. And if the loan adds up to less than $10,000, you don’t have to worry about charging interest. Remember, you’ll need to report all taxable and tax-exempt interest. You will use IRS Form 1099-INT.
If you want to pay the interest on the loan, you can do this as long as it doesn’t add up to more than the individual gift limit. For 2018, that limit is $15,000 per person, which is $1,000 more than in 2017. Or you can reduce the amount of a loan by that much with no tax implications, and that amount becomes a gift. If you are going to be repaid for the entire loan, however, then remember the IRS will not consider any part of it as a gift. So make sure you report the interest, even if you plan to forego some or all of the interest.
If you received a loan from a family member or friend, you would face new rules on personal deductions for 2018. The 2018 personal deduction is $12,000 for individuals and $24,000 for married couples. For most people, the amount of mortgage interest you’ll deduct will put you below that ceiling, especially for married couples.
Your 2017 Taxes
You still must pay income tax on the interest gained from any personal loans that you made in 2017. If you calculated the AFR, or set a higher interest rate, and have a proper contract, it will be easy to determine how much interest you earned. If you need to determine the AFR, the IRS rate table lists the rates back to 2000.
If you lent the money for mortgage purposes, the family member or friend who received the mortgage loan will be more likely to deduct the mortgage interest in 2017, because the personal interest deductions were changed for 2018. If you’re filing your 2017 taxes, you will want to itemize deductions if your mortgage interest and other deductions push you above the $6,350 mark for individuals and $12,700 mark for couples.
Go to this calculator to stay up to date on AFR rates.
For your personal loan tax calculator, complete with monthly rates, go to Bankrate's Loan Calculator.
- Tax Act Blog: Family Loans: Does the IRS Care if I Lend My Kids Money?
- Tax Act Blog: Gift Tax: Do I Have to Pay When Someone Gives Me Money?
- Market Watch: How to Lend Money to a Relative Without Getting Whacked by the IRS
- Zack's: Do You Have to Pay Taxes on Interest Collected From a Personal Loan?
- Five Cent Nickel: Are Personal Loans Taxable?
- LBMC: Tax Effects of Interest-Free Family Loans
- 415 Group: How to Set Up an IRS-Approved Family Loan
- Interest.com: Should You Lend Your Kids Money to Buy a Home?
- Protect yourself from loss by asking the borrower to sign a loan agreement specifying the loan's interest rate and repayment terms.
- If you make a no-interest personal loan of more than $10,000, you must document the transaction. Without documentation such as a loan agreement, the IRS can assume that you did not report the interest and, through "imputed interest," tax you for interest payments you never received.
Karen Gardner is a former feature editor and writer and is now a freelance writer. She looks forward to doing her family's taxes each year, and likes to write about home finances and money subjects for the rest of us.