A summer wedding. A fall vacation. A winter filled with gift exchanges and a few minor home improvement renovations if you’re a homeowner. These are all valid reasons to take out a personal loan.
All of these seasonal scenarios are also followed by spring taxes...and likely plenty of questions.
Is personal loan interest tax deductible?
Do I include cash from a personal loan as part of my income?
How do I report a canceled personal loan?
Taxes can be, well... one of the most taxing parts of personal finance—especially when you’re dealing with a new financial scenario, like a personal loan. Stay tuned as we learn more about personal loans and how they affect your taxes.
Can a Personal Loan Interest Deduction Be Claimed on Taxes?
Generally, personal loan interest is not tax deductible, but there are exceptions that you may be able to take advantage of when taking out a loan for personal use.
You may be able to claim personal loan interest as a tax deduction if some or all of the interest can be linked to these types of loans:
- Business expenses
- Qualified higher education expenses
- Taxable investments
We’ll cover these exceptions more in just a bit. But first, let’s start by defining what it means to claim interest on your taxes.
Meet James. James works hard. In fact, he made $75,000 last year before taxes (great job, James!).
Like all outstanding citizens, James is a taxpayer so James is getting ready to file his taxes for his latest tax year. He knows that the Internal Revenue Service calculates taxes as a percentage of his income. So he starts crunching the numbers based on his cool 75K.
But wait, James! Don’t you know about deductions? A tax deduction is a reduction of taxable income. You can qualify for a dedication if you’re married, have children, make charitable donations, contribute to an IRA account, install energy efficient appliances, or even when shopping for clarinets (see for yourself). Another common standard deduction is interest paid on loans.
After James applies his deductions, his taxable income drops down to $55,000. And those income tax savings add up to a lot of extra clarinet lessons!
So, What Types of Personal Loan Interest are Tax Deductible?
Let’s get back to personal loans. Similar to mortgage loans, auto loans, and credit cards, personal loans often have an interest rate built into their repayment schedule. But typically, only homeowners can deduct interest, since mortgage interest qualifies for a tax deduction.
As a rule of thumb, interest is NOT tax deductible on car loans, home equity loans, credit card debt, or any other type of loan used for personal reasons. But before you file your tax return, check to see if you fall into any of the following three personal loan exceptions:
☑️ Using a Personal Loan for Business Purposes
Business loans aren’t always easy to get, especially if you’re self-employed. If you use any of your personal loan funds to form or run your small business, the associated paid interest can be deducted when you file your personal taxes. Website development, purchasing inventory, and marketing can all qualify as business expenses (FYI, if your small business files taxes, you cannot claim business expenses on both your personal AND business tax forms).
☑️ Using a Personal Loan for Qualified Higher Education Expenses
One in eight Americans have student loan debt. While these loans are one option for tackling the high cost of further education, funds from a personal loan can also be used to pay for college tuition, fees, and associated activity costs. This means that interest payments on a personal loan used to manage certain education expenses, including student loan interest, may be deductible.
☑️ Using a Personal Loan for Taxable Investments
If you use the money from your loan to invest in stocks, mutual funds, or bonds, you may be able to deduct any paid interest on your taxable investments. But keep in mind there may be tax implications in the form of short-term or long-term capital gains and you’ll need to itemize your deductions to take advantage of this deduction, which isn’t common.
Examples of Deducting Personal Loan Interest from Taxes
For the sake of seeing these exceptions in action, let’s check in with James. Did you know he took out a personal loan with a total loan amount of $10,000?
He used $2,000 to buy new equipment for his business. Then he spent $3,000 on his college tuition (business owner and student? Way to go, James!). Then he invested $1,000 in the stock market—a real estate company, a few tech stocks, and some ETFs. He used the remaining $4,000 for personal expenses, specifically an incredible Caribbean vacation (James works hard and plays hard).
Can James deduct any interest paid on this loan and receive tax benefits? Most likely, yes!
He’ll want to work with a trusted tax professional to help him with the details, but he can likely deduct interest paid on the portions of the loan that paid for his business expenses and college tuition. He may be able to deduct the interest paid on the portion used to buy stocks, but this is trickier to accomplish since it has to be an itemized deduction. As for the part of the loan that fueled his getaway, because it’s a personal expense, he’ll have to settle for a tan instead of a deduction.
Uncle Sam has no interest in the interest on these types of loans
The IRS doesn’t have to know about all your monthly payments on borrowed money. It’s not because they don’t care, it’s just that interest paid on a debt consolidation loan, for example, can’t be deducted since a bank loan isn’t considered income.
The same goes for credit cards. If you’ve maxed out your line of credit, you’re likely paying hefty interest fees. But there are no tax credits for credit card debt. So if you’re trying to save on credit card interest, the best option is to either refinance via a balance transfer or boost your credit score so you can request a lower rate.
Are Personal Loans Considered Taxable Income?
We know what you’re thinking. If personal loans count as part of your taxable income, are you really saving anything by deducting the associated interest?
This could be a valid point—except personal loans are not considered taxable income. Taxable income is defined as money you earn after deductions from your adjusted gross income (AGI), primarily received through either a job or investments. Similarly to a personal line of credit, personal loans are funds received with an intent to pay back, so they do not increase the borrower’s taxable income. This helps us understand why personal loan interest is not tax deductible.
What Happens if Your Personal Loan is Canceled?
If you took out a personal loan and then defaulted on your payments, you’ll have to take a few extra steps come tax time.
Depending on your lender, upon default, your lender will issue you a cancellation of debt, or COD. You’ll then receive a 1099-C tax form that will need to be submitted to the IRS with your return.
While a loan in good standing doesn’t count as taxable income, unpaid and canceled debt does. Here’s why.
When you borrow a dollar, but give a dollar back, your bank account remains neutral (assuming there were no origination fees or a high amount of interest). But when you borrow a dollar and only pay back fifty cents, you’re essentially ahead by two quarters. Unlike personal loans in good standing, unreturned loans qualify as income in the eyes of the IRS, and are taxed accordingly.
One Final Tip
By the way, taxes are hard and your personal finances are not something to be careless with. When it comes to deducting personal loan interest, we recommend that you always work with a trusted tax professional (James does) for accurate tax liability purposes.
When taking out a personal loan, don’t count on paid interest being tax deductible. At the same time, knowing when interest paid on personal loans can be deducted will ensure you’re not handing over more money than you have to to good ole’ Uncle Sam.
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