How Do Personal Loans Affect Your Taxes?

Article Summary:

In most cases, personal loans don’t affect your taxes. They aren’t considered taxable income, and, therefore, you don’t have to report them on your tax return. However, there are exceptions. Personal loans can have tax consequences if you default on a personal loan or you use them to pay for qualified business or student expenses.

A personal loan can be a smart investment if you are looking to make a big purchase or pay off high interest debt. However, you may be wondering how this personal loan will affect your taxes. After all, your wages are taxable. What about a personal loan? Here’s what you need to know.

Are personal loans considered taxable income?

Unlike income, the money from a personal loan does not really belong to you. You have to pay it back. Therefore, a personal loan is not considered taxable income. Usually, it can’t be used as a tax deduction either. So, for the most part, personal loans will not affect your taxes. However, there are exceptions. This article provides more information on when personal loans are taxable income. Continue reading this article to learn about under what circumstances a personal loan will affect your taxes.

Why does a personal loan not usually affect my taxes?

Generally, a personal loan or the interest on a personal loan does not affect your taxes. Here are two reasons why.

  • Personal loans aren’t income by the IRS definition. As mentioned above, a personal loan is not considered income, so it is not considered taxable income. In addition, the interest on a personal loan is also not regarded as taxable income either.
  • Personal loans are typically used to pay for personal expenses. Using a personal loan for personal expenses means the interest accumulated on the loan is not deductible as a business expense.

However, there are some exceptions when personal loans can affect your taxes.

Canceled debt

If a lender forgives or cancels a personal loan, it may become taxable income. Here is the relevant paragraph from the IRS:

“In general, you must report any taxable amount of a canceled debt as ordinary income from the cancellation of debt on Form 1040, U.S. Individual Income Tax ReturnForm 1040-SR, U.S. Tax Return for Seniors or Form 1040-NR, U.S. Nonresident Alien Income Tax Return as “other income” if the debt is a nonbusiness debt, or on an applicable schedule if the debt is a business debt.”

Canceled debt can occur in a variety of situations. However, it typically happens if you default on your payments or settle for a lower amount with the lender. In these cases, the creditor will send you a Form 1099-C, which you must include in your tax return. Often, the amount you end up paying in taxes will be less than the outstanding balance on the loan – saving you money. However, it is still important to be aware of the tax consequences of a canceled personal loan.

Exceptions to cancellation of debt income

There are multiple situations when you don’t have to include forgiven or canceled debt in your taxable income. Here is the list of exceptions published by the IRS:

  • Amounts canceled as gifts, bequests, devises, or inheritances
  • Certain qualified student loans canceled under the loan provisions that the loans would be canceled if you work for a certain period of time in certain professions for a broad class of employers
  • Other education loan repayment or loan forgiveness programs to help provide health services in certain areas.
  • Amounts of canceled debt that would be deductible if you, as a cash basis taxpayer, paid it
  • A qualified purchase price reduction is given by the seller of property to the buyer
  • Amounts from student loans discharged on account of death or total and permanent disability of the student.

When is a personal loan tax deductible?

Typically, personal loans are not tax-deductible, but there are a few exceptions where they may qualify for tax deductions. However, it is not the amount of the loan itself that is tax-deductible but the interest amount you have paid on the loan. This article provides a detailed analysis of when personal loans are tax-deductible, but here are the Cliff Notes.

Scenarios where personal loans may be tax-deductible

You may be able to take a personal loan interest deduction if you use the loan for business expenses, qualified higher education expenses, or taxable investments. However, you must meet specific criteria, as explained below.

  • Business Expenses. The interest you pay on a personal loan may be tax-deductible if you use it to finance a business expense, such as buying supplies, purchasing office furniture, or a business vehicle. If it’s a reasonable business expense, you can deduct its cost as a tax deduction, and that includes the interest. To claim the deduction on interest, you must be legally liable for the loan and itemize the portion of the interest paid attributable to business expenses.
  • Student Loans. You may be able to claim a student loan interest deduction on the interest paid if the student loan is used exclusively to pay for qualified education expenses or refinance a pre-existing student loan. You may be able to deduct up to $2,500 in interest per year.
  • Taxable Investments. Loans used to purchase taxable investments, like stocks, bonds, and mutual funds may be eligible for the interest deduction. Importantly, tax-advantaged bonds are not eligible. To determine if you are eligible for the investment interest deduction, you must itemize your deductions. Your deduction will also only be used to offset investment income for the year. In a situation where you don’t have enough investment income, you may be able to carry over the interest expenses to the next year.

Should I apply for a personal loan?

Personal loans are typically not tax-deductible, but that does not stop them from being a useful financial tool. Personal loans allow you to consolidate debt, pay for unexpected expenses, finance a major purchase, and usually don’t require collateral. Typically, they also give you access to larger amounts and at lower interest rates than credit cards. For more details on the pros and cons of a personal loan read this article and SuperMoney’s list of the best personal loans currently available. I also recommend reading more about how to qualify for a personal loan.

Key takeaways

  • In most cases, personal loans don’t affect your taxes because it’s not considered income and they are typically used for personal expenses.
  • However, personal loans can affect your personal loans, if the loan is canceled or if you use it to finance qualified business and student expenses.
  • You may be able to take a personal loan interest deduction if you use the loan for business expenses, qualified higher education expenses, or taxable investments.
  • Although personal loans don’t typically affect your taxes, they allow you to consolidate debt, pay for unexpected expenses, and finance a major purchase without requiring collateral.

 

Article Sources
  1. Topic 431. Canceled debt – IRS
  2. Topic 505. Interest expense – IRS
  3. Business expenses -IRS
  4. Best personal loans – Supermoney
  5. Personal loans industry study – SuperMoney
  6. How to qualify for a personal loan – SuperMoney
  7. Are home improvement loans tax deductible – SuperMoney