Borrowers can use personal loans for all kinds of purposes, but the Internal Revenue Service (IRS) cannot treat loans like income and tax them, with one significant exception: Personal loans are not considered income for the borrower unless the loan is forgiven.

In other words, you cannot be taxed on loan proceeds unless the lender grants the borrower a reprieve on paying back the debt owed. This is known as loan forgiveness. In the event a loan is forgiven, the proceeds associated with the original loan are considered a cancellation of debt (COD) income. And COD income can be taxed.

Personal Loans

Personal loans can be loans made by a bank, an employer, or through peer-to-peer (P2P) lending networks. They can be used for just about anything by a borrower, but some common uses include consolidating debt, planning a wedding, or making other large purchases. While home loans and car loans offer collateral (i.e., the bank may take your home or car if you do not pay), personal loans often are unsecured, which means they are made with no collateral. As such, they are riskier, and interest rates may be higher. Because personal loans must be repaid, they are not considered taxable income.

If you're interested in taking out a personal loan but are uncertain about what you can afford, then a personal loan calculator may prove useful in determining the right monthly payment amount, term length, and interest rate to suit your needs.

How Do People Use Personal Loans?

daftarlapak303.commissioned a national survey of 962 U.S. adults between Aug. 14, 2023, to Sept. 15, 2023, who had taken out a personal loan to learn how they used their loan proceeds and how they might use future personal loans. Debt consolidation was the most common reason people borrowed money, followed by home improvement and other large expenditures.

Cancellation of Debt (COD) Income

A debt is canceled when a lender allows a borrower to not pay back part or all of the loan. Debt cancellation often can be obtained by negotiating with the lender for relief, often due to financial distress, or by completing debt settlement programs. Once a debt is forgiven, it is considered income. Borrowers should receive a 1099-C tax form.

Exceptions to the Rule of COD Income

However, there are a number of exceptions to the rule. If a loan is forgiven as a gift by a private lender, for example, there is no income to the borrower. Debts discharged by bankruptcy also are excluded from gross income.

This rule has some additional stipulations. If a loan is forgiven as a gift to the amount of more than $17,000 (for the tax year 2023), then the total amount that's forgiven chips away at the lifetime exemption from the gift tax (set at $12.92 million for 2023).

In the midst of the Great Recession, Congress passed the Mortgage Debt Relief Act of 2007. The act allowed taxpayers to exclude from their incomes any discharge of mortgage debt on their homes up to $2 million. The act applies for the years 2007 through 2017 and covers debt reduced through restructuring and foreclosure.

Workers employed in certain professions for a broad class of employers also may have their student loans canceled tax-free. In addition, some student loan repayment assistance programs, such as the one from the National Health Services Corps, are given tax-exempt treatment.

COD Strategies

There are several ways to arrange for the cancellation of a debt. As noted above, the most common include negotiating with creditors, completing a debt settlement program, and filing bankruptcy.

Negotiating with creditors is difficult, but sometimes provisions are written into a loan that allows borrowers to reduce their debt under certain circumstances, such as financial hardship. Debt settlement programs can be an option for borrowers who consistently have fallen behind on their payments. With one of these programs, a debt settlement company will negotiate with your creditors to settle your debts for less than what you owe. However, these services cost expensive fees, can damage your credit, and may lead to collection lawsuits against you.

The Bottom Line

Personal loans typically won't be considered income and, as such, cannot be taxed, with one main exception: Should a lender cancel part of a borrower's personal loan debt, then the canceled portion is considered taxable income. This rule has a few exceptions of its own, so if you owe taxes on forgiven personal loan debt, it might be worth double-checking if your canceled debt qualifies for exemption.