Do you pay taxes on personal loans?

If you’ve recently taken out a loan or are considering one, you might wonder how it may affect your taxes. The good news is that loans are generally not taxable income, except in rare cases. In some situations, you may even be able to deduct the interest paid on the loan.

Let’s explore why personal loans are not taxed when they might be considered taxable and under what circumstances the interest you pay could be tax-deductible.

Is a personal loan taxable income?

Most types of loans aren’t seen as income for the simple reason that they must be repaid. The IRS classifies income as money you earn from a job or through investments to keep for your own use. Since you don’t make money from a loan you take out, the IRS doesn’t consider a loan as income when you’re filing your taxes. That means you don’t need to report the money you borrow on your personal tax return.

When are personal loans taxable?

A borrower can use a personal loan to pay for just about anything. A personal loan isn't normally subject to any income tax because it’s considered a type of debt to be repaid rather than income. However, there is one specific situation when a personal loan could be considered taxable income: if your debt is canceled or forgiven.

Cancellation of debt (COD)

If a borrower defaults on a loan, they may be able to negotiate with the lender to have part of the debt canceled or forgiven. When a lender issues a Cancellation of Debt (COD), the borrower is no longer responsible for paying back the remaining balance. However, the forgiven amount is typically considered taxable income, as it was not paid back.

Along with the COD, a lender may send a 1099-C form for the borrower to report the canceled debt and unpaid amount when filing their tax return. When the borrower submits their tax returns, they will owe income taxes on the remaining balance.

For example, if you take out a $15,000 personal loan and pay back $10,000 but then default on the remaining $5,000. If the lender agrees to cancel the $5,000 balance, you would then need to report that as taxable income on a 1099-C form and pay taxes on it.

There are some exceptions, however. If your debt is discharged in bankruptcy, it will not be considered taxable income. Additionally, if you are insolvent (meaning you owe more than your assets) when the debt is forgiven, you may be able to exclude part or all of the forgiven debt from your taxable income.

Can a personal loan be a tax deduction?

While loans are not tax-deductible, the interest you pay on them can be in certain situations. Generally, interest on personal loans, like those for auto loans or credit cards, isn’t tax-deductible because personal loans are usually for personal expenses, which are rarely deductible. However, there are some exceptions where the interest on a personal loan may be deductible under specific circumstances.

When is personal loan interest tax-deductible?

What you use a personal loan for can affect whether your interest is tax-deductible. For example, home improvements or debt consolidation are considered personal, and interest is not deductible. However, as noted above, certain instances can allow you to deduct interest paid from your personal loan.

Business expenses

You can deduct business-related costs from your interest payments using a personal loan to finance your business. These can include travel, equipment, office space and maintenance for a company vehicle. If you keep itemized records of how you spent the money, you should be able to deduct that paid interest. Make sure your lender allows this type of use for a personal loan.

Taxable investments

If you borrow money for certain investments like purchasing specific stocks, you can potentially deduct up to the amount of the investment income you earn for the year. You’ll need to keep records that prove you used the money for investing.

Education expenses

A personal loan for qualified educational expenses can be eligible for tax-deductible interest payments. The same is true for refinancing a student loan with a personal loan. Eligible student expenses can include tuition, textbooks, lodging and more. If you can prove all of the money went to these expenses, you can possibly deduct $2,000 or more in annual interest payments.

On what loans is interest tax-deductible?

While personal loans normally don’t qualify for tax-deductible interest, the following loans generally meet the criteria:

• Mortgages: Borrowers can deduct interest on a mortgage when they use the funds to buy, construct or renovate a home. Additionally, if they purchased mortgage points to lower their interest rate, those payments are also deductible.
• Home equity loans: Interest payments on a home equity loan or home equity line of credit (HELOC) can be deductible if the funds are used for qualifying home improvements that add value to the property.
• Student loans: Higher education expenses may qualify for a tax deduction on the interest paid, as mentioned earlier. Unlike personal loans, you don’t need to itemize how you use the funds to claim this deduction. However, you won’t be eligible if someone can claim you or your spouse as a dependent or if you file as “married filing separately.”
• Business loans: Like personal loans used for business expenses, you can deduct interest if the funds are used for business purposes, even if you’re self-employed. However, family loans used for business purposes don’t qualify for deductions, as they are not considered formal borrower/lender relationships.

FAQs about personal loans and taxes

Here’s what other people are asking about personal loan tax implications.

How do personal loans affect taxes?

Personal loans generally won’t affect how you file your tax returns because the IRS doesn’t consider loans taxable income. A personal loan will only affect your taxes if your lender cancels or forgives the loan.

Are there any tax benefits to getting a personal loan?

Other than the possibility of deducting interest for certain expenses, personal loans don’t offer specific tax benefits. However, they have the potential to affect your credit score in positive ways.

Are interest payments for personal loans tax-deductible?

Generally, interest payments on personal loans are not tax-deductible. However, if the loan is used for business expenses, education costs, or investments, the interest may be deductible.

Do I have to report a personal loan on my taxes?

You may need to report a personal loan on your tax return in the following situations:

• Part of your loan was canceled or forgiven
• You used the loan for business expenses
• You used the loan for qualified educational expenses
• You used the loan to purchase taxable investments

What is a gift tax?

The bottom line: You typically don’t have to pay taxes on personal loans

Remember to stay organized by tracking and itemizing your spending. That way, there won’t be any surprises come tax season. By understanding whether your loan will be considered taxable income or if you’re eligible for interest deductions, you’ll set yourself up for a smooth, stress-free experience. 

If you’re ready to take the next step, securing a personal loan is easy—start today with a prequalification from Rocket Loans℠. 

Rocket Loans does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.