Are Personal Loans Taxable or Tax-Deductible?
When it comes to borrowing money, it's always a good idea to understand the tax implications of a loan or credit line, including personal loans.
For example, with mortgages, the interest paid may be deductible if you fit the IRS rules for that deduction. Or, when credit card debt is written off, the amount is considered taxable income.
Generally, you can’t deduct personal loans or personal loan interest on your income tax return.
Like with almost everything in personal finance and taxes, there exist exceptions to rules.
The good news here is that there are some instances when personal loans are tax deductible, so it’s important to know the ins and outs before you file your tax return.
If you're thinking about applying for or already have a personal loan, learn everything about how it is relevant when it comes to filing your taxes.
Are Personal Loans Considered Taxable Income?
Your income taxes are called income taxes for a reason: you’re being taxed on your income, or wages you’ve earned throughout the year.
Your job salary or W-9 earnings are perfect examples of income that you’re taxed on. Anything that counts as income must be taxed (except for certain cases where it may be tax deductible, like nonprofit earnings).
With that logic, wouldn’t a loan be considered income? A personal loan would seem to fit that bill because it’s a form of funding granted to you to spend on yourself (on a vacation, a big purchase, consolidating high-interest debt, etc.).
Not so. A personal loan isn’t considered income for the same reason it’s called a loan: The money isn’t yours. Therefore, personal loans are not considered taxable income.
It’s money that’s borrowed and meant to be paid back to the lender, so it doesn’t fall under the definition of income, and thus, can’t usually be considered for an income tax deduction.
However, the operative word here is usually. Just because a personal loan isn’t income doesn’t mean it isn’t entirely exempt from tax deductions.
In fact, when it comes to loans and tax deductions, it’s not a matter of establishing a loan as a piece of income.
The loan balance is not what gets deducted; rather, it’s the interest you pay that qualify for exemptions on certain types of loans. (And for lenders, the amount they receive in interest payments counts as income.)
Some Loan Interest is Tax Deductible
The Internal Revenue Service (specifically, through the Tax Reform Act) has its own rules and regulations about what kinds of loans -- specifically what type of interest paid on a loan -- is tax deductible. Some loan interest is, some isn’t.
Here are some examples of loan interest that is tax deductible:
- Student loan interest
- Some types of medical expense interest
- Property-related loan interest, such as mortgages, home equity loans, property investment loans, etc.
- Credit card interest on business purchases
What doesn’t qualify for tax deductions
However, the IRS also specifies when you can’t make a tax deduction on certain loans, which is why you never hear about deducting interest on things like using a credit card for personal use, or your car loan payments -- neither one qualifies for a deduction.
Personal loans also fall in the same camp and aren’t usually considered tax deductible.
But there’s a chance you might overlook some possible tax deductions without looking a bit closer.
Here are two times when personal loans can be claimed for a tax deduction:
Your personal loan was forgiven
When a lender forgives a borrower of a personal loan, either partially or in full, the original loan amount is considered income, and the remainder becomes tax deductible.
In a rare instance when a personal loan qualifies as income, the original balance you’ve paid back becomes what’s called Cancellation of Debt income, which gets taxed. The remaining debt discharged, no matter how large or small, is tax exempt.
Say you took out a $10,000 personal loan last calendar year, and by the end of 2017, you paid off half of it, with interest.
The lender decides to absolve you of paying back the remaining $5,000 and your interest rate. The balance paid off is taxed, the rest is not.
The good news is that not only do you not need to pay taxes on the rest of the loan, you don’t need to pay off the loan.
If you’ve had been released from your responsibility to pay a personal loan, make note of this in your tax return forms to receive a deduction and avoid paying taxes.
Remember that in order for a personal loan to count as Cancellation of Debt income, it must come from a certified lender or bank. Under-the-table loans from a friend or family member are classified as gifts, can’t be taxed, and thus can’t receive a tax deduction.
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You used a personal loan for business expenses
Just like business expenses on a business credit card are tax deductible, so are business expenses funded by a personal loan.
You can deduct interest from a personal loan if it was used for legitimate business purposes.
For example, if you used 80 percent of your loan for personal reasons, like financing a big party, buying a boat, and refinancing some credit card debt, those would not be tax deductible.
But if you used the remaining 20 percent to buy office equipment, travel expenses to a work-related convention or two, and other business costs, you can deduct the interest on that portion of your personal loan.
Keep personal and business expenses separate
It’s easy to mix up personal and business expenses together, and hard to separate them once it comes time to file after expenses have piled up.
If you took a personal loan and bought a car with it, and you drove the car partially for work, and partially for personal reasons, you’ll have to provide clear evidence of how much the car was driven for business in order for the IRS to determine how much value from the personal loan’s interest payments you’ve made are tax deductible.
It’s recommended not to commingle personal and business expenses for this very reason, especially where personal loans are concerned.
To avoid making it too complicated or complex, follow some of these tips for pinpointing personal loan tax deductions:
Keep good records
Before itemizing your deductions on Schedule C, do the math and break down individually the amount of personal loan interest that may qualify for a deduction.
Your bank lends you a $50,000 personal loan; $30,000 goes towards the purchase of a new car and partially financing some home improvements, and $20,000, to start up a new business.
On the loan, you paid off $1,000 in interest last year, but only $400 of it is tax deductible since 40 percent of the personal loan was reserved for business use.
Capitalize instead of deducting business expenses
This can be particularly useful for people who’ve used a personal loan for business property expenses.
Capitalizing means including on your income tax form the interest you’ve paid as part of a business property purchase from a personal loan.
It’s not a tax deduction, but it will mean less profit -- hence, less taxable income -- to report, a clear-cut way to save money.
Consult with a tax professional
Check with a licensed tax professional or certified public accountant (CPA) if the prospect of filing taxes is too intimidating. The cost of hiring a qualified financial agent can help offset any potential costs incurred from filing errors or tax return mistakes.
They’ll be able to guide you through the filing process, make recommendations, and pinpoint personal loan tax deductions that you may have overlooked.
In the end, that means less money to the government, more money in your pocket, and greater experience in finding ways to claim tax deductions whenever taking out a personal loan in the future.
Here are some of the personal loan lenders you can choose from: