Is Borrowed Money Considered Income?

Borrowed money is almost never income. If you take out a loan and pay it back, the Internal Revenue Service usually doesn't care about it. Loans that you don't pay back, though, could turn into income and you could have to pay taxes on the money you got but didn't repay.

Income and money are two different things. Generally, income comes from trading something of value -- like your time at work or the use of your property if you're a landlord -- for cash or an equivalent. Interest or dividends you earn from investing are also income, because you're letting that bank or company use your money and they're paying you for it.

If you take out a loan, though, you aren't making yourself better off. You get money from the loan, but you also go into debt, effectively canceling out the money you get. This is why it isn't income.

When you don't pay your loans back, they turn into income. To the IRS, a $2,000 loan is a wash, because you get $2,000 and you go $2,000 into debt and eventually have to pay it back. If you only pay back $900 of the loan, though, the remaining $1,100 balance essentially becomes free money that you got from the lender. Because of this, you will have to pay income tax on the money if you can't use one of the IRS' loopholes.

Another loan that can turn into income is the loan you get when you borrow money out of your 401(k) plan at work. The IRS lets your employer offer 401(k) loans if it chooses, but you usually have to pay them back within five years or right after you separate from the employer that's offering the 401(k) plan. If you don't, the law treats what you still owe as a withdrawal from the account. It turns into income and you have to pay income tax on it -- plus a 10 percent penalty for withdrawing the money before turning 59 1/2 years old.

The downside of the IRS not caring about any loans that you take and pay back is that it generally also doesn't care about the interest you pay. Other than certain special types of loans, you can't write off the interest you pay on personal borrowing. The IRS just treats it as another expense that you pay for with your personal money -- like buying a toaster or paying for a movie ticket.

This rule has a few exceptions, though. As a way of supporting homeownership and supporting students who choose to get additional education, the government may let you write off your mortgage interest and student loan interest.