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How A Personal Loan Can Affect Your Taxes

6-Minute ReadOctober 12, 2021


When you're filing your tax returns, it's important to get all of your information right. If you've recently taken out a loan, or if you're considering it, would that technically count as taxable income? That's something you'll want to know before you submit your taxes so you can avoid any legal trouble.

The article below will discuss personal loan tax implications to keep in mind, such as when a loan is or isn’t considered taxable income, and when your interest paid may be tax deductible.

Is A Personal Loan Subject To Income Tax?

Generally, most types of loans are not seen as income, for the simple reason that they have to be repaid. Income is classified by the IRS as money that you earn from a job or through investments to keep for your own use. Since you don't earn anything from a loan you take out – primarily because you have to pay it all back – loans are not considered income as far as your filing your taxes is concerned.

When Are Personal Loans Taxable?

A personal loan can be used by a borrower to pay for just about anything. As it's considered a type of debt to be repaid rather than income, a personal loan is not normally subject to any income tax.

That being said, there is one particular instance where a personal loan can be reconsidered as income: if the debt is canceled or forgiven.

Cancellation of Debt (COD)

When a borrower defaults on a loan, they can sometimes work out a deal where a portion of their debt can be canceled, or forgiven. When a lender issues a COD, the borrower is no longer responsible for the remaining loan amount. However, because that balance isn't being repaid anymore, it becomes taxable income.

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

Let's say you borrow a $15,000 personal loan. You pay back $10,000 over time but, for financial reasons, cannot pay the remaining principal and default on the loan. If your lender agrees to cancel the remaining $5,000, you'll have to report that number on your 1099-C as income, since you're no longer going to pay it back. You'll then owe taxes on that $5,000 forgiven debt.

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Does A Personal Loan Qualify For A Tax Deduction?

Loans themselves are not tax deductible, but the interest on them can be. Personal loans, like auto loans and credit cards, do not generally qualify for tax deductible interest payments, because a personal loan is typically used for personal reasons – personal expenses are rarely deductible.

There are again exceptions to this rule, though, where interest on a personal loan can be tax deductible.

When Is Personal Loan Interest Tax Deductible?

What you use a personal loan for can affect whether your interest is tax deductible or not. Uses like home improvements or debt consolidation are considered personal, and interest would not be deductible.

However, as stated above, certain instances can allow you to deduct interest paid from your personal loan:

  • Business expenses: If you use a personal loan to finance your business, you can deduct business-related costs from your interest payments. These can include travel, equipment and office space, as well as 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.
  • Investments: If you borrow money for investing, such as purchasing stocks, you can potentially deduct up to the amount of investment income you earn for the year. Again, you'll need to keep records that prove you used the money for investing.
  • Education expenses: Taking out a personal loan to pay for qualified educational expenses, or refinancing a student loan with a personal loan, can both be eligible for tax deductible interest payments. Eligible student expenses can include tuition, textbooks, lodging and more. If you can prove that all of the money was used for 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 can qualify for tax deductions on interest paid, as discussed earlier. Unlike with personal loans, you're not required to itemize how you spend your funds to take the deduction. However, you'll be ineligible for the deduction if anyone can claim you or your spouse as a dependent, or if you use the "married filing separately" status.
  • Business loans: Similarly to using a personal loan for business expenses, interest on business loans can be deducted if the funds are used for business purposes, even if you're self-employed. Family loans for business don't qualify for deductions, as they aren't considered legitimate borrower/lender relationships.

FAQs About Personal Loans And Taxes

Are there any tax benefits to getting a personal loan?

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

Can you use a personal loan against the income tax on your tax return?

You can pay your taxes with a personal loan if you get a big tax bill you can’t afford. Be aware that most lenders won’t offer loan amounts lower than $1,000.

Are payments for personal loans tax deductible?

As with auto loans and credit card debt, personal loan payments aren’t tax deductible. Interest may be deductible in some of the scenarios discussed above.

Final Thoughts

You want to be prepared come tax season, with all of your forms in order and your income ready to report. Knowing ahead of time whether your loan will be considered taxable income or if you can deduct any interest payments can help ensure another smooth tax year for yourself, and avoid any trouble with the IRS. If you do have tax deductible interest, be sure you've been itemizing your spending properly to avoid any post-filing surprises.

If you're looking to get a personal loan you can get started today with 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.