[A Comprehensive Guide] Are Personal Loans Taxable?

Are Personal Loans Treated As Taxable Income?

What are Personal Loans?

Personal loans are loans made by banks, employers, or through peer-to-peer lending networks. You can use personal loans to plan a wedding, consolidate your debt, make large purchases, carry out home improvement and repairs, moving costs, etc.

In most cases, personal loans don't require collateral (unsecured). So, they are riskier and attract more interest rates. But since you have to repay these loans, they aren't considered taxable income. 

What is Taxable Income?

Taxable income refers to the portion of your gross income that's taxable. It includes both earned and unearned income. 

Examples of taxable income are as follows: 

• Wages, salaries, tips, bonuses, vacation pay, severance benefits, and commission. 

• Interest and dividends. 

• Certain types of disability payments. 

• Unemployment compensation 

• Jury pay and election worker pay

• Strike and lockout benefits 

• Cancellation of Debt (Unless excluded by law or regulation). 

• Alimony

• Recovery of items deducted in previous years. 

• Trust/estate income

• Specific scholarships, fellowships, grants, etc. 

Here are examples of nontaxable income: 

• Gifts and most inheritances. 

• Life insurance proceeds. 

• Dividends on veteran life insurance loans. 

• Child support. 

• Insurance reimbursement of medical expenses not previously deducted. 

• Welfare payments 

• Compensatory damages for personal physical injury or physical illness.

• Workers compensation. 

Are Personal Loans Treated As Taxable Income?

No! Personal loans aren't treated as taxable income because they are liabilities that you need to repay. It doesn't matter whether you got the loan from banks, credit unions, peer-to-peer lenders, etc. You don't report personal loans on your tax returns. 

They are only treated as taxable income when the loan is canceled or forgiven. In that case, the borrowed money becomes cancellation of debts (COB) income. And you should report your COB income when filing taxes for the year the loan was canceled.

In What Situation Are Personal Loans Considered Taxable?

You don't need to file personal loans on your income taxes report, except if your loan is canceled or forgiven during the tax year. The canceled amount will be treated as cancellation of debts (COB) income in such a situation. 

What is Cancellation of Debt (COD) income?

Cancellation of Debt (COD) income refers to the amount of money a lender cancels or forgives from the loan a borrower owes.  

In most cases, borrowers get cancellation of debt through negotiation with the lender for relief, especially if they are going through a hard time. 

For instance, if you owe a personal loan of $10,000 that you can't pay in full, the lender is willing to collect $7000 to settle the account. The difference between what you owe and what you actually paid ($3,000) is the cancellation of debt (COD) income. And it's taxable.

So, you might receive a form 1099-C with information about the canceled debt, and you need to file this document in your tax return. 

Are Forgiven Personal Loans Considered Taxable Income?

Yes, forgiven personal loans are taxable income. But there are a few exceptions. Your forgiven personal loan is not taxable under the following circumstances: 

• If you obtain debt cancellation during bankruptcy. 

• You were already insolvent (that is, you owe more debt than current assets) when your lender forgives your debt. 

• When you are a beneficiary of some student loans forgiveness program. 

If you belong to any of the above categories, part or all the forgiven debts may not be included in your gross income. 

What If You Received a Loan From a Family Member or Friend?

Loans from your friend or a family member are not taxable income.

However, if they don't charge you interest or you don't repay the loan, there may be tax implications for them. The IRS may consider the unpaid loan as a gift depending on the loan amount. That is your friend or family who gifted you the loan would file a gift tax form and pay the taxes accrued to it.

What is the Annual Gift Tax Exclusion? 

Annual gift tax exclusion refers to the amount of money you can transfer as a gift to another person without incurring a gift tax. As of 2022, for instance, if a loan from a friend or family member is less than $16,000, you don't need to file a gift tax form. 

Exceptions Where Gifts Aren't Taxable

There are exceptions where gift tax isn't taxable even if the value exceeds the annual gift tax exclusion. 

• Gifts to qualifying charities. 

• Any amount is sent as a gift for tuition or medical expenses. 

• Gifts to political organizations. 

• Gifts to a spouse. 

Exceptions to Tax Rule

There are exceptions to the cancellation of debt (COD) tax rules. Some of them are as follows:

• Qualified purchase price deduction the seller of a property gives to the buyer. 

• Any amount forgiven from Federal, private, or educational student loans. 

• Loans canceled as gifts or inheritances. 

• Qualified student loans are canceled after working in a particular profession for a specific time. 

• Some educational loan repayment or cancellation programs provide health services in specific areas. 

• The amount of canceled debt that would be deductible when repaid.

Furthermore, IRS may not include your canceled debt as part of your taxable gross income if the debt falls in any of the following categories: 

• If the lender forgives or cancels the debt under title 11 bankruptcy. 

• If the cancellation of the debt was due to insolvency. 

• Cancellation of qualified farm indebtedness. 

• Cancellation of qualified real property business indebtedness. 

• The cancellation of qualified principal residence indebtedness. But this is subject to an agreement entered into and evidenced in writing on or before January 2026. 

Tip: If you intend to negotiate debt cancellation with your lender, it's better to discuss your situation with a debt or bankruptcy attorney first. 

Are Personal Loans Tax Deductible?

Personal loans are liabilities you owe as opposed to your taxable income. So, you can't deduct the interest you pay on them. However, there are a few exceptions to this rule.

It's possible to claim personal loan interest as tax-deductible if you can link some or all of the interest to - business expenses, qualified higher education expenses, and taxable investment. 

• Business Expenses:

Getting a business loan is challenging if you are self-employed. But if you use personal loans to fund or run your small business, you can get a tax-deductible interest on the amount linked to the business expenses when you file your personal taxes.  

Businesses like website development, purchasing inventory, and marketing qualifies for business expenses. 

• Qualified Higher Education Expenses:

One in eight Americans has student loan debt. And according to the Federal Reserve Bank of St. Louis, the collective student debts owed in the United States as of August 2022 is $1.75 trillion. 

But most Americans need to learn that they can also use funds from a personal loan to pay for qualified college tuition, fees, and associated activities cost. And the interest payment on personal loans used to fund these qualified education expenses may be deductible.

• Taxable Investments:

If you take out personal loans to invest in stocks, bonds, or mutual funds, you may be able to deduct interest paid on your taxable investments. But remember that there may be tax implications from the short and long-term capital gains from these investments. 

However, some lenders and lending marketplaces may not allow you to use personal loans for business expenses, student loan refinancing, or investments. That's why you should always do your research before taking out a personal loan. 

How Does Deducting Personal Loan Interest From Taxes Work?

To better understand how deducting personal loan interest from taxes works, I will give you a real-life example. 

Let's assume Mc Donald (a business owner and student) took out a personal loan of $15,000. He used $3000 to buy six new sets of computers for his business.

Then he spent $5,000 to refinance his student loan. He further invested $2000 in the stock market - a real estate company, a few tech companies, and some ETFs. He used the remaining money for an incredible vacation on the Maldives Islands. 

The question now is - Can McDonald deduct any interest paid on this loan and receive tax benefits? Yes, he can. 

He can get deductible interest on the amount he used to purchase computers for his business (business expenses), his educational expenses (student loan refinanced), and the amount he invested in the stock market. 

What types of loans have Tax Deductible Interest?

Here are five types of loans with tax-deductible interest:

#1 Student Loans 

You can get a deduction of up to $2500 in interest payments annually when you use student loans for qualified higher education expenses. These expenses include tuition fees, lodging, textbooks, etc. Even if you don't itemize, you can still take this deduction. 

However, certain conditions may disqualify you from getting deductible interest on your student loan. These conditions cover:

• If you use the married filing separately status. 

• If someone can claim you or your spouse as a dependent. 

#2 Mortgages 

Although the Tax Cuts and Jobs Act of 2017created new rules for deducting mortgage interest payments, you can still deduct mortgage interest. Especially when you use the money to buy, build, or improve a home. 

Additionally, if you paid mortgage interest points, the payments are also deductible. But if you are qualified for these deductibles, you must itemize your deductions to benefits. So, you may need to work with a tax expert. 

However, the Tax Cuts and Jobs Act reduced the maximum mortgage principal eligibility for interest deductible from $1 million to $750,000 for new loans. Additionally, the TCJA almost doubled the standard deductions, so itemizing may not be necessary for taxpayers.

#3 Second Mortgages 

You can also get deductible interest on second mortgages payment like a Home Equity Loan (HEL) or Home Equity Line of Credit (HELC). But the mortgage value limit still applies to the combination of your first and second mortgages. 

Additionally, your chances of getting deductible interest on your second mortgage payment are higher when you improve your home value and extend its life. 

#4 Investment Interest Expenses 

You can get an itemized deduction for the interest paid on a loan used to buy an eligible taxable investment. For instance, when you take out a margin loan to buy stocks, you can claim the deduction. However, the interest paid on loans used to buy tax-advantaged municipal bonds might not be deductible. 

#5 Business Loan 

If you are an entrepreneur or own a small business, you can get deductible interest on business loans. But you must meet three conditions to qualify for deductions on your business loans; 

• You must be liable for the debt. 

• It's essential to have a genuine debtor-creditor relationship. 

• You must intend to repay the debt; of course, there must be an expectation to pay the credit. 

For instance, if a friend or family member offers to give you money to start a business. And you later decided to repay the gift plus interest, and such an interest is not deductible. 

However, if you take out a personal loan to buy a new set of computers for your business, you may be able to deduct your interest payment. 

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FAQs

1. Can You Use a Personal Loan to Pay Your Taxes?

Yes! You can take out a personal loan to pay your tax bill. Even though it will leave you deeper in debt, the interest rate and repayment plans can sometimes be cheaper and more consistent than IRS payment plans and other financing options.

You can also use a credit card to pay your taxes if your current credit score or financial condition doesn't qualify you for a personal loan. But bear in mind that credit card interest rates are higher than that of personal loans. 

Alternatively, you can work with the IRS on a short-term repayment plan that allows you to pay the total tax bill within 180 days; or agree on a long-term repayment plan that will enable you to pay off your account gradually.

Again, the IRS payment agreement may come with interest and penalties. An IRS payment plan may not affect your credit score. But personal loans and credit cards may affect your credit score. Consider these facts before making any decision. 

2. What Kind of Personal Expenses is Tax Deductible?

You can get a tax deduction from any of the following personal expenses; 

• Mortgage interest.

• State and local taxes.

• Charitable Donations. 

• Medical expenses and health savings account. 

• 401(k) and IRA contributions. 

• Student loan interest. 

• Education expenses.