Sara Routhier, Managing Editor and Outreach Director, has professional experience as an educator, SEO specialist, and content marketer. She has over five years of experience in the insurance industry. As a researcher, data nerd, writer, and editor she strives to curate educational, enlightening articles that provide you with the must-know facts and best-kept secrets within the overwhelming world o...

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Joel Ohman is the CEO of a private equity-backed digital media company. He is a CERTIFIED FINANCIAL PLANNER™, author, angel investor, and serial entrepreneur who loves creating new things, whether books or businesses. He has also previously served as the founder and resident CFP® of a national insurance agency, Real Time Health Quotes. He also has an MBA from the University of South Florida. ...

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Reviewed by Joel Ohman
Founder, CFP®

UPDATED: Feb 22, 2012

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Not only “can” borrowers be taxed on interest-free loans, they “will” be taxed on them. As unfortunate or nonsensical as that may sound, interest-free loans, whether they be auto, home, or personal loans, are classified by the IRS as cancellation of debt income, or COD income. COD income is essentially an income that an individual shouldn’t have, but wound up receiving through some special agreement. Regardless of the way somebody receives COD income, the IRS expects to taxes from it.

 

COD Income

 

To better understand how COD income works, imagine a borrower who owes the bank $100,000. The borrower feels he will never be able to pay the debt off, so he pleads with the bank, and through some chain of events the bank agrees to discharge all of the debt. The IRS views that discharged, or forgiven debt, as what can essentially be viewed as money that borrower shouldn’t have—a gift of sorts. Consequently the IRS will expect to be taxed on that borrower’s $100,000 gift.

 

Likewise, when a borrower receives a traditional personal loan of any type at no interest, the IRS expects to receive its cut from what it views as a “gift.”

 

Robert W. Wood, a Forbes contributor and CA tax attorney, says after 30 years of practicing law he would rank COD income as one of the biggest tax traps he’s come across.

 

How does the IRS do this?

 

An example of how the IRS actually processes interest-free personal loans is when an employer gives money to an employee at no interest. Let’s say the employer gave his employee $1,000, and the two parties agreed that there would be no interest.

 

If the IRS determines a loan like this would carry a 5 percent interest rate, they would take the total (which has no interest), and reduces the principal of it in their books so that the difference between their newly recorded principal and the original amount is 5 percent.

 

“In effect, the IRS ‘attributes’ interest even when the parties don’t intent—and don’t want—it,” explains Wood.

 

Sometimes interest-free is a worse deal

 

Wood explains the problem with taxable interest-free personal loans by revealing the ruling on a recent court case, Brooks v. Commissioner. Brooks was given a personal loan from his employer that his employer agreed to forgive so long as Brooks remained employed for five years. Brooks held up his end of the bargain, and so did his employer.

 

But the employee was surprised when the IRS insisted he pay taxes on the loan—and all of the interest that it would have accrued over its lifetime.

 

Brooks sued the IRS, claiming the interest was forgiven by his lender, and thus shouldn’t be taxable. But the court ruled in favor of the IRS, forcing Brooks to pay.

 

The worst part? Brooks argued that had the interest not been forgiven by his employer, he could have written the interest off, and saved money. Instead, he was unable to write the personal loan interest off, since it technically didn’t exist, but was still forced to pay the full amount of taxes on it.