On a couple of left leaning blogs around Indiana there is some inaccurate information about the income tax consequences of loan repayments. I am going to clear them up here just like I did on WOWO earlier today.
One of the blogs, Taking Down Words, is a Democratic Blog in Indianapolis. Her post on personal loans and the potential IRS consequences for 2006 is misleading and inaccurate:
TDW asks the question: Anyone want to bet on whether Kelty reported the extra personal income on his 2006 tax return?
I used to read Taking Down Words; however, I stopped a few months ago because she reminds me of Sean Hannity; except she is a Democrat. I cannot abide people who feel that their Party is always right and that other Parties are evil.
Here are the basic rules concerning the tax consequences of loans:
1. A loan is not considered income since you will be paying back. It is considered a liability.
2. When you repay the principal portion of a loan this does not have income tax consequences for the person you are repaying.
This is best explained with an example. Lets say that I loan TDW $10,000 on Dec 31st 2006 so that she can take some accounting and legal courses to prevent her from posting inaccurate claims on her blog. Lets say she signs a promissory note promising to pay me back $1000 per month plus $100 in interest for the next ten months. Payments will start in January of 2007.
TDW will have no tax consequences in 2006, it will not be reported on her personal tax return in any way. She has not received personal income, she has taken out a loan that she is responsible to pay back.
Lets assume she makes all ten payments to me in a timely fashion...
TDW will have no tax consequences in 2007; however, at the end of the 10th month she no longer will owe me any money. That liability will have been paid off.
I will have tax consequences in 2007. She is paying me ten $100 interest payments in 2007. So I will report $1000 of interest income on my tax return in 2007. The $10,000 in principal payments I received are not taxable; they are a return of principal.
It is that simple.