Banks offer many types of loans to help their customers finance various purchases, including:
- Mortgages for houses
- Home equity loans for renovations or debt consolidation
- Auto loans to help finance cars and trucks
- Personal loans for financing needs that do not fall into a more restricted category. Most don’t require collateral, and you can usually use the money however you want.
Loans have their pros and cons, and when it comes to money it is always important to consider the tax implications. For example, mortgage interest is often deductible as an itemized deduction on your tax return. Tax savings can make a huge difference in the overall cost of owning a home.
Unfortunately, other types of loans generally do not offer tax benefits. Indeed, they can sometimes have negative tax consequences.
Below, we’ll take a closer look at personal loans to show you how they can affect your taxes.
Borrowed money is not taxable income – usually
The first thing to recognize is that when you take out a personal loan from a bank or other financial institution, it will not be treated as taxable income. Of course, you get the money now, but you also assume the obligation to pay it back at some point. Just as you will not be able to deduct the principal repayment when you repay the loan, you will not have to pay tax on the loan proceeds when you receive them.
An exception to this rule is when you get a personal loan from someone who has a relationship with you rather than an impartial third party financial institution. For example, if your employer gives you a forgivable personal loan and doesn’t expect to be repaid, the IRS might choose to treat that money as a form of compensation. In this case, you will need to record the âloanedâ amount as income. However, such loans are extremely rare, and as long as you are expected to repay the loan in good faith, it would be difficult for the tax authorities to argue that you should treat the loan as income.
Another exception is interest income. If you borrow money and keep it for a period of time in your high yield savings account, the interest you earn is reportable and taxable.
Interest on personal loans is generally not tax deductible – with a few exceptions
Once you take out a loan, you will need to pay interest at regular intervals. Those used to deducting interest on other types of loans – especially mortgages and home equity loans – might wonder if interest on personal loans is also eligible for the deduction.
The answer to this question depends on how you use the money.
The general rule of the IRS is that if you take out the loan for purely personal purposes, the interest on the loan is not tax deductible.
If the loan was taken out for an eligible deductible purpose, however, you can deduct the interest you pay on it.
For example, if you borrow money to make an investment, the interest paid may be treated as eligible investment interest eligible for a deduction from your investment income. This happens most often in the brokerage context, when you take out a margin loan against the value of your investment portfolio and use it to buy additional investment securities. In this case, the interest is almost always deductible because there is a clear and direct link between the loan and your investing activity.
With a personal loan, you are allowed to use the proceeds for any purpose you see fit. You will therefore have to prove that you used the loan to make an investment in order to deduct the interest accordingly. However, if you can do that, then you will have a reasonable argument that the interest should be deductible.
The same argument applies to other types of deductible expenses. Using a personal loan to start a business makes interest a business deduction.
Because there are many possible cases in which your interest payments may become a tax deduction, it is important to document your use of the funds.
Loan forgiveness usually creates taxable income
The tax-exempt nature of a personal loan depends on whether you will have to repay it. If the loan is later canceled, you will usually need to include the canceled amount as income. This is because of the provisions known as debt cancellation, which requires taxpayers in most situations to recognize the canceled debt as income.
However, the rules vary from situation to situation, depending on what prompted the creditor to give up your personal loan. If you file for bankruptcy and get a court order canceling your personal loan debt, specific bankruptcy laws prevent you from having to recognize the canceled debt as taxable income.
In contrast, a decision by your creditor not to force you to repay the loan may result in taxable debt income forgiveness. This can happen if you enter into a debt settlement agreement and your creditor gives up all or part of a personal loan. This is because likely tax liability makes settled debts much more costly than you might think just by looking at online listings from professional debt settlement companies.
It’s always worth checking to see if any special exemptions apply, but you’ll usually have to pay the IRS something if your loan is canceled.
Know the score with personal loans and taxes
Personal loans are designed to be flexible and easy to manage because they will have fewer restrictions and specific requirements than specialty loans like mortgages or home equity loans. However, the tax advantages are not always so great with personal loans. By knowing the general rules governing personal loans and the tax consequences, you will further avoid unpleasant surprises and manage your tax liability appropriately.