Promissory Notes and Taxes: What Lenders and Borrowers Need to Know

Most people think of promissory notes as a borrowing and lending tool, which they are. But what often gets overlooked is the tax side of the equation. Whether you are the one handing over money or the one receiving it, a promissory note can have real implications come tax time. Ignoring those implications does not make them go away.

Here is what both lenders and borrowers need to understand about how the IRS treats promissory notes and the transactions that flow through them.

The Loan Itself Is Not Taxable Income

If you borrow money through a promissory note, the amount you receive is not considered income. You are not taxed on it because you are expected to pay it back. This applies whether the loan comes from a bank, a private lender, a family member, or anyone else. The principal you receive does not show up on your tax return as income.

By the same logic, when a lender hands over money, that transfer is not a deductible expense. It is a loan, not a gift or a business cost. The tax implications come later, when interest is paid, forgiven, or charged below the market rate.

Interest Income Is Taxable for Lenders

If you are the lender and your promissory note charges interest, that interest income is taxable. The IRS treats it as ordinary income, which means it gets added to your gross income for the year and taxed at your regular income tax rate.

This applies even if the borrower is a family member and the arrangement feels informal. If interest is being paid, the IRS expects you to report it. Lenders should keep clear records of every payment received and how much of each payment represents interest versus principal repayment.

The Applicable Federal Rate and Why It Matters

Here is where things get more complicated for family loans and private arrangements. The IRS sets something called the Applicable Federal Rate, or AFR, which is the minimum interest rate the government expects to see on private loans. The AFR changes monthly and varies depending on the loan term.

If you lend money to a family member at zero interest or at a rate below the AFR, the IRS may treat the arrangement as if interest were charged at the AFR anyway. This is called imputed interest. The lender is expected to report that imputed interest as income even if they never actually received it, and the borrower may be treated as having received a gift equal to the forgone interest.

For small loans, there is some relief. Loans of $10,000 or less are generally exempt from the imputed interest rules. Loans between $10,001 and $100,000 have a more limited version of the rule that depends on the borrower's investment income. But for larger loans, charging at least the AFR is the cleaner path from a tax standpoint.

Interest Deductions for Borrowers

Whether a borrower can deduct the interest they pay on a promissory note depends on what the loan was used for. The IRS does not simply allow all interest to be deducted just because it was paid.

Interest on a loan used for business purposes is generally deductible as a business expense. Interest on a loan used to purchase investment assets may qualify as investment interest, subject to certain limitations. Interest on a personal loan used for everyday living expenses is typically not deductible.

If you are a borrower who used a private loan for business or investment purposes, keep thorough records showing how the funds were used. That documentation is what supports your deduction if you are ever questioned.

What Happens When a Debt Is Forgiven

This is the part that surprises a lot of people. If a lender forgives all or part of a promissory note, meaning they tell the borrower they no longer need to repay some or all of the remaining balance, the forgiven amount is generally treated as taxable income to the borrower.

The IRS considers canceled debt to be income because the borrower received money they no longer have to pay back. The lender is typically required to issue a Form 1099-C reporting the canceled amount, and the borrower must include it on their tax return.

There are exceptions, including debt discharged in bankruptcy and certain cases of insolvency, but for most private loan forgiveness situations the borrower is on the hook for taxes on the forgiven balance.

Bad Debt Deductions for Lenders

If a borrower defaults on a promissory note and the lender is unable to collect, the IRS allows lenders to claim a bad debt deduction in some circumstances. For individuals, this is treated as a short-term capital loss, which can be used to offset capital gains and, to a limited degree, ordinary income.

To claim a bad debt deduction you need to be able to show that the debt was legitimate, that you made a genuine effort to collect, and that the debt is truly uncollectible. The promissory note itself is important documentation here. A signed note with a clear loan amount and repayment terms is much more credible evidence of a real loan than a casual verbal agreement.

Gift Tax Considerations

When money moves between family members without proper documentation or below-market interest rates, the IRS may look at part of the transaction as a gift rather than a loan. Gifts above the annual exclusion limit, which is $18,000 per recipient for 2024, may require the lender to file a gift tax return.

This does not always mean gift tax is owed, since the lifetime exemption is substantial, but it does mean filing requirements can kick in. Structuring a family loan properly with a signed promissory note and an interest rate at or above the AFR is one of the cleanest ways to keep the transaction in loan territory rather than gift territory.

Keep Records on Both Sides

Whether you are the lender or the borrower, good recordkeeping is your best protection. Hold onto the original signed promissory note. Track every payment made and received, noting the date, the total amount, and how much went toward interest versus principal. Save bank statements that show the transfers.

If the IRS ever questions the arrangement, having clean documentation of a legitimate loan with real repayment activity makes a significant difference. The combination of a signed promissory note and a clear payment history is hard to argue with.

When to Talk to a Tax Professional

For small, straightforward loans the tax implications are manageable on your own. But if you are dealing with a large loan, a family arrangement with below-market interest, a forgiven debt, or a defaulted note you want to write off, talking to a CPA or tax advisor is worth the time.

Tax rules around private lending are not always intuitive, and the cost of getting it wrong, whether that means unexpected income, missed deductions, or gift tax filings you did not know you needed, adds up quickly. A short conversation with a professional can save you a significant headache when you file.