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Income Tax on Loan Taken from Friends or Relatives

Updated on: 20 May, 2024 05:06 PM

Loans from family members or friends are not taxable. Whether the loan is with or without interest, it becomes tax-free for the borrower. However, if the lender charges interest from the borrower, he or she has to pay taxes on any interest that is earned from the loan.

What are the restrictions under income tax act on giving and taking personal loans?

To regulate personal loans from friends and relatives government has made certain rules and regulations and also implemented various restrictions. They are as follows:

  • The first restriction is one cannot accept a loan exceeding a limit of Rs 20000 in cash or by bearer cheque. The transaction must be through a bank account in various ways, such as a payee cheque, electronic transfer, bank draft, and so on. This rule is even applied if the total amount is borrowed in various parts or installments. The limit of total transfer through cash is Rs 20000.
    For example :
    If Mr. X has taken a loan of Rs 10,000 earlier (maybe even by cheque or electronic transfer) and now intends to borrow another Rs 15,000 in cash, he cannot do so, as the balance would exceed Rs 20,000.
    In case of violation of this rule, the receiver of the loan will be liable to pay a penalty equal to the amount accepted in violation, i.e., the Total amount accepted like Rs. 25000/- if Mr. X accepts this 15000 also. However, the violation will be decided by the tax officer who will be dealing with your case, whether it is reasonable or not for a violation.
  • The second restriction is on the repayment of the same loan. The repayment should also be paid wholly or partially through cash or bearer cheque up to the limit of Rs 20000. If this rule is violated, the penalty will be applied to the borrower.
  • The third restriction is on loans between Indian residents and Non-resident Indians(NRIs). An Indian can only accept loans in Rupees from Non-resident Indians (NRIs) or a person of Indian origin.
  • The period of this type of loan is also restricted to not more than three years.
  • The interest rate is also restricted to 2% over the bank rate prevailing in the market.
  • The fourth restriction is that an Indian resident can only give loans to a Non-resident Indian (NRI) friend and relative. This loan can only be given for a period of one year and has to be interest-free. The amount of loan is also restricted and has some limits.
  • The fifth restriction is an Indian resident can only take foreign exchange loans from his close non-resident relatives and not from other non-residents.
  • The amount of such a loan cannot exceed $250,000. The loan should be taken for at least one year and that too interest-free.

Tax Liability of Earning Interest Income from the Loan Given to Friends and Relatives

The tax implications of earning interest income from loans given to friends and relatives depend on the nature of the loan and your relationship with the recipient:

Interest on loans to relatives:

  • Exempt from tax: The interest earned on loans given to specified relatives is tax-exempt, provided the following conditions are met:
    • The loan is documented with a written agreement specifying the terms and conditions, including interest rate and repayment schedule.
    • The interest rate charged is at least equal to the prevailing bank rate for similar loans.
    • The loan is not given in cash exceeding Rs. 20,000 (unless through banking channels).
  • Specified relatives: include spouse, siblings, parents, children, grandchildren, grandparents, great-grandchildren, spouse's parents and siblings, and their spouses.
  • Taxable: If any of the above conditions are not met, the interest income will be taxable under the head "Income from Other Sources" at the applicable tax rate based on your income slab.

Tax implications of borrowing or lending from or to NRIs

Borrowing and lending transactions involving residents and non-residents in India are governed by the Foreign Exchange Management Act (FEMA). According to FEMA, a resident individual can borrow from an NRI in foreign currency or rupees, provided certain conditions are met. Likewise, an NRI can lend to a resident individual in foreign currency or rupees, subject to specific conditions. Key conditions include:

  • The loan transactions must be conducted through banking channels.
  • Loans should be utilized for personal or business purposes, excluding real estate or capital market investments.
  • The loan tenure should range from a minimum of one year to a maximum of three years.
  • The interest rate on the loan should not exceed the prevailing market rate or the rate set by the Reserve Bank of India (RBI).
  • Reporting of the loan to the RBI is required within 30 days of receipt or disbursement.

Tax Implications: Taxation of interest paid or received on the loan depends on the residential status of the borrower and the lender. Various factors contribute to the tax implications, including the nature of income, loan type, and the Double Taxation Avoidance Agreement (DTAA) between India and the NRI's country of residence. Key points include:

  • Interest paid by a resident to an NRI on a foreign currency loan is taxable as other income in the hands of the NRI, subject to a withholding tax rate of 20% (plus surcharge and cess) or the rate specified in the DTAA, whichever is lower.
  • Interest paid by a resident to an NRI on a rupee-denominated loan is taxable as other income in the hands of the NRI, subject to a withholding tax rate of 30% (plus surcharge and cess) or the rate specified in the DTAA, whichever is lower.
  • Interest received by a resident from an NRI on a loan in foreign currency or rupees is taxable as other income in the hands of the resident, subject to standard tax rates.
  • The interest paid or received on the loan may qualify for deduction or exemption under specific sections of the Income Tax Act, such as section 24 for housing loan interest, section 80E for education loan interest, section 10(15) for interest on specified bonds or deposits, etc.

Pro Tax Tip - For individuals looking to manage their tax obligations efficiently, services such as income tax e-filing provide a convenient platform to file returns. It's crucial to stay informed about the last date to file ITR and utilize resources such as online refund status to track refunds. Additionally, being aware of income tax slab rates and income tax notice procedures can help taxpayers navigate their obligations seamlessly.

Receiving money from friends through e-wallet/UPI

With becoming cashless, it is now very easy to transfer money to other people through the phone. This is done through UPI, e-wallets, and so on. Even the debts of friends can be cleared through e-wallets.

  • If in case these transfers are receipts of debts owed to you, you don't have to pay tax on them. In such a case, if scrutiny is done by the income tax department, then you have to submit a written note stating the transaction is the settlement of debts.
  • If this type of settlement is a simple receipt, it may be treated as a gift and thus are not taxable.

For example: If you go out with six friends on a trip and you spend the complete expenditure with the total amount of Rs 35,000. Afterward, your friends pay their share through an app or UPI giving you back a total amount of Rs 30000. These transactions will be taken as gifts and will not be taxed. As this transaction will be a settlement of the debts owed to you, and it is tax-free.

Note: The amount should not exceed the sum of 50,000. Any bigger amount transferred by friends through e-wallets will be taxable.

Deductions for the loan taken or given

Interest repayment for a home loan that is taken from friends or relatives can be claimed as a deduction under section 24. The deduction can only be claimed when the construction of the house is complete or the individual receives the possession. The Income Tax Act does not clearly specify that deductions will be available only for loans from specified banks.

The deduction limit for the interest paid is limited to ₹2 lakh per year for a self-occupied property, and there is no limit for the let-out property. You can only claim the deduction for the interest if the construction of the house property is completed and in five equal installments.

On the other hand, repayment of the principal on a home loan borrowed from friends or relatives can’t be claimed as a deduction under this section.

For Example:

“Mr. A purchases a house for Rs 10 lakh. He took this loan from his relative, Mr. V, for the purchase of this property. The loan is repayable in 10 equal installments with an interest of Rs 5% per annum. He repaid the principal of Rs 1 lakh and an interest of Rs 50000 for the financial year 2021-22.”

“Mr. A is eligible for a deduction under Section 24 for interest repayment of Rs 50000. But he can’t claim a deduction under Section 80C for the principal repayment as the deduction is not available for the repayment of the loan from friends or relatives.”

If you've acquired a loan from friends, relatives, or financial institutions and seek to claim deductions or wish to understand the tax implications on interest paid or received. Book eCA to optimize your income tax filing and maximize your tax savings.

Frequently Asked Questions

Q- Is taking loan from friends or relatives taxable?

No, a loan from friends or relatives is tax-free. No borrower is taxable for any sort of loan. However, such loans should not be in cash, as discussed above.

Q- Who is responsible for taxation on the interest earned from giving loans to friends or relatives?

If lender of the loan charges interest from friends or relatives, is liable to pay tax on the interest earned.

Q- Can I make an interest free loan to a friend?

Yes, any person can make an interest-free loan or loan on a subsidized rate to friends or relatives however, such loan should not be granted or recollected as cash. The transaction must be through a bank account in various ways, such as a payee cheque, electronic transfer, bank draft, and so on.

Q- Do you have to pay taxes on a loan from a family member?

When a loan is given to any friend or family member, it may be given with a relaxed rate of interest; however, any interest charged by the lender of the loan from friends or relatives is liable to be taxed, and the lender should pay tax on the interest earned.

CA Abhishek Soni
CA Abhishek Soni

Abhishek Soni is a Chartered Accountant by profession & entrepreneur by passion. He is the co-founder & CEO of Tax2win is amongst the top 25 emerging startups of Asia and authorized ERI by the Income Tax Department. In the past, he worked in EY and comes with wide industry experience from telecom, retail to manufacturing to entertainment where he has handled various national and international assignments.