Personal Loans and Your Taxes
If you have a personal loan now, or are considering getting one to pay down credit card debt or make a large purchase in the future, knowing if there are any potential tax implications can help when it comes time to file your return. While there is no set personal loan tax, knowing when and how a personal loan might impact your taxes can help ensure you don’t miss out on any potential deductions. Read on to find answers to a few of the most commonly asked questions about personal loans and your taxes.
Are Personal Loans Tax Deductible?
A personal loan could help you save money by consolidating high-interest debt, or provide the funds you need to pay for an emergency or unexpected expense. While there are exceptions, generally, personal loans don’t affect your taxes. Here’s why:
1. It's not income
The money you receive from a personal loan isn’t added to your taxable income, and you don’t have to pay taxes on the money you borrow.
2. It's for personal use
Personal loans are often for personal use, and you generally don’t get to deduct personal expenses.
3. Even when allowed, interest is deductible
Some types of loans can qualify for a tax deduction. But generally, you can deduct only the interest portion you pay on the loan (and sometimes origination fees in the case of student loans, for example), not the loan amount.
When Is a Personal Loan Tax Deductible?
Depending on how you use the funds, there are a few circumstances when the interest you pay on a personal loan may be tax deductible.
For example, if you take out a loan solely to pay for qualified education expenses or to refinance a student loan, you may be able to claim the student loan interest deduction. Similarly, you may also be able to take an investment interest expense or business expense deduction if you used a personal loan for these purposes. However, some lenders and lending marketplaces (like LendingClub) may not allow you to take out a personal loan for these types of purchases.
Additionally, an unsecured personal loan won’t qualify for mortgage-related deductions because the loan isn’t secured by your home (more on this below). This is true even if you take out the loan for home improvements.
Which Loans Are Tax Deductible?
The interest payments on certain types of loans are generally deductible if you meet all the criteria. Here are a few examples of loans that may qualify:
1. Student loans
If you took out student loans for qualified higher education expenses, you may be able to deduct up to $2,500 in interest payments each year. For the interest deduction, qualified expenses may include tuition, fees, lodging, textbooks, and other necessary expenses. The definition varies for certain higher education tax credits.
You can take this deduction even if you don’t itemize. However, you can’t take the deduction if you use the married filing separately status or if someone can claim you or your spouse as a dependent. The deduction also phases out based on your modified adjusted gross income.
While the Tax Cuts and Jobs Act of 2017 created new rules for deducting mortgage interest payments, it didn’t get rid of the deduction altogether.
Individuals can still deduct interest on mortgages when they use the money to buy, build, or improve a home. If you paid mortgage interest points, those payments can also be deductible. In both cases, if you qualify, you must itemize your deductions to benefit.
The law did limit how much interest you may be able to deduct. Now, you can deduct interest on up to $375,000 worth of mortgage debt (or, $750,000 if you’re married and file jointly). Higher limits of $500,000 and $1,000,000 apply if you took out the mortgage before Dec. 16, 2016.
3. Second mortgages
Interest payments on second mortgages, such as a home equity loan (HEL) or home equity line of credit (HELOC) may also be deductible. However, the mortgage value limit applies to the combined balance of your first and second mortgages.
To qualify, you need to use the proceeds from the loan to substantially improve the home by increasing its value or extending its life. In other words, building an addition might qualify, but making purely cosmetic changes that don’t increase its value wouldn’t.
4. Investment interest expenses
The investment interest deduction is an itemized deduction for the interest you pay if you borrow money to buy an eligible taxable investment. For example, you may be able to claim the deduction if you have a brokerage account and took out a margin loan to buy stocks. But buying tax-advantaged municipal bonds won’t count.
If you qualify, the deduction is limited to the net investment income you earned at your ordinary income tax rate. You may be able to carry over interest expenses if you can’t claim the full deduction this year.
5. Business loans
If you run a business or are self-employed, you may be able to deduct the interest you pay on a business loan (or the portion of a personal loan) you use for business purposes. To qualify, you must:
- Be liable for the debt
- Intend to repay the debt, and the credit must be expected to be repaid
- Have a true debtor-creditor relationship
For example, if a family member offers to give you money to start a business and you later decide to repay the gift plus interest that won’t count. But if you take out a personal loan to buy supplies and equipment for your business, then you may be able to deduct your interest payment.
Perhaps you take out an auto refinance loan for a vehicle that you use for business half the time. You may be able to deduct half of the interest on the loan.
How Does Canceled Personal Loan Debt Affect Your Taxes?
If a creditor cancels, discharges, or forgives part of your debt, the portion of the loan that you didn’t repay may be considered taxable income. Often, this occurs if you fall behind on payments and agree to a settlement with the creditor.
The creditor will send you a Form 1099-C, Cancellation of Debt, which shows how much debt was canceled. You may need to include the canceled debt in your income and pay taxes on the amount. However, there are exceptions, and you may be able to exclude the amount from your income if you’re insolvent (i.e., your liabilities exceed your assets).
The Bottom Line
With the potential tax consequences in mind, you can be more strategic about when and why you take out a loan. In particular, small-business owners can benefit, as some loans may qualify them for a deduction even if they use only a portion of the proceeds for business expenses.
Remember, tax planning is a year-round process and an important part of managing your personal finances. Many individuals often think about using a tax refund to pay down debt. However, a better approach might be to use a more reliable source of funds—such as a personal loan.