The Internal Revenue Services makes an important distinction between earned income and loans. If you work at a job or are paid a sales commission or any other fee for your services, then you earn income, which is taxable. If you use money from a loan to buy a house, car or other property, that money isn't considered income and isn't taxable. There are important features of loans that you should be aware of when filing your federal tax returns.
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Tax Treatment of Loans
You don't have to report loans on your tax return, nor do you have to pay income tax on loans. Because you're obligated by a written agreement to repay the loan, the IRS doesn't consider the money to be income, either earned or unearned. Money that you earn by using the loan, such as rent paid by tenants in a property that you financed with a loan, is taxable income.
The IRS doesn't consider a personal loan to be income, but the agency may classify such a loan as a gift. If you receive a loan from a parent against your inheritance, for example, the parent may be obligated to pay gift taxes unless you can prove that the loan has to be repaid. You do this by setting down the terms of repayment in written form and making sure the transaction is labeled as a loan on the instrument that conveys the money — a certified check, for example. The estate documents should also document the loan, as well as the repayment terms.
Loan Interest Deductions
The tax law allows you to deduct certain forms of interest that you pay on loans. Mortgage interest, for example, is fully deductible: You subtract it from your gross income before figuring your taxable income. Investment-loan interest, student loan interest and home-equity loan interest are tax-deductible under certain circumstances; consumer-debt interest — such as that charged on credit cards — is not. You must provide documentation of the interest paid, which must be provided by the bank or lending institution that extended the loan or is currently servicing the loan.
If your employer extends you a loan, tax treatment depends on the terms of repayment. If you must unconditionally and personally repay the money, then it's a loan. If your pay and bonuses are increased or set to match the loan amount and conditioned on your remaining on the job, then the IRS considers the loan compensation, and income tax is due. The IRS also considers any advances against future earnings to be compensation, and fully taxable, rather than as a loan.