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Are personal loans taxable income?

Are Personal Loans Taxable Income?

Updated on January 9, 2024

 Loans

Understanding Taxable Income

Taxable income typically encompasses all earnings, such as salaries, wages, freelance income, gratuities, and bonuses that an individual receives within a year.

However, there are certain types of income that are not taxable, such as:

  • Compensation from accidents and personal injuries
  • Spousal support payments
  • Child maintenance payments
  • Federal tax refunds
  • Grant money
  • Monetary gifts
  • Scholarship funds
  • Benefits for veterans and welfare recipients

When is a Personal Loan Considered Taxable Income?

Your loan may become taxable depending on how you use it. Using it for a business expense is a typical example. The interest you pay on this loan can be tax deductible for your business. You should only use the money for your business costs exclusively and consult a tax advisor to understand any implications.

Forgiveness of Debt (FOD) Earnings

When you find it challenging to settle your outstanding liabilities, there are several strategies you can employ to have that debt pardoned. These strategies encompass bargaining with the creditor, making use of debt resolution schemes, and declaring bankruptcy.

  • If the creditor consents to forgive your debt, they will issue an FOD and provide you with a 1099-C form. You are required to declare the discounted sum on this form and submit it to the IRS during your tax filing.

Exemptions to the FOD Earnings Regulation

Occasionally, you are not obligated to declare the pardoned loan sum as income. Suppose the amount is forgiven as a gift from a private lender, or the debt is ignored in the lender's will. In that case, the amount does not have to be reported as income.

Additionally, taxpayers do not have to pay taxes on forgiven mortgage debt up to $750,000 due to the Mortgage Debt Relief Act passed during the Great Recession. The Consolidated Appropriations Act of 2020 extended these tax exemptions for forgiven mortgages to 2025 in light of the COVID-19 pandemic.

COD Strategies

There are several ways to arrange for the cancellation of a debt. As noted above, the most common include negotiating with creditors, completing a debt settlement program, and filing for bankruptcy.

Negotiating with creditors is difficult, but sometimes provisions are written into a loan that allows borrowers to reduce their debt under certain circumstances, such as financial hardship. Debt settlement programs can be an option for borrowers who have consistently fallen behind on their payments. Borrowers work with a debt counselor to set up a payment program that, if completed, will result in the remaining debt being forgiven.

What Happens if a Personal Loan is Forgiven?

In rare cases, when a lender forgives a portion of a personal loan, the borrower may need to pay taxes on the discounted amount. This is because forgiveness turns that portion of the loan into income, according to Kendall.

For example, if you received a loan for $10,000 and had $2,000 forgiven, you would need to pay taxes on the $2,000.

If the debt cancellation is taxable, you should receive a Form 1099-C from the debt collector or lender with information about the canceled amount.

Types of loans with taxable interest.

Types of Loans with Tax-Deductible Interest

Interest on specific loan types may be tax-deductible if you satisfy all the requirements. Here are some examples of loans that could potentially qualify for tax-deductible interest:

Mortgages

While the Tax Cuts and Jobs Act of 2017 created new rules for deducting mortgage interest payments, it didn't eliminate the deduction.

Individuals can still deduct mortgage interest when they use the money to buy, build, or improve a home. If you paid mortgage interest points, those payments could also be deductible. You must itemize your deductions to benefit in both cases if you qualify.

The legislation has set a cap on the amount of interest you can deduct. Currently, you can deduct interest on mortgage debt up to $375,000 (or $750,000 if you're married and filing jointly). If you secured the mortgage prior to Dec. 16, 2016, the higher limits of $500,000 and $1,000,000 are applicable.

Student Loans

If you took out student loans for qualified higher education expenses, you could deduct up to $2,500 in interest payments each year. For the deduction of interest, eligible expenses could encompass tuition, fees, accommodation, textbooks, and other essential costs. The interpretation differs for specific 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 separate status or if someone can claim you or your spouse as a dependent. The deduction also gradually reduces depending on your modified adjusted gross income.

Business Loans

Suppose you run a business or are self-employed. In that case, you can deduct the interest you pay on a business loan (or the portion of a personal loan) you use for business purposes. To be eligible, you need to:

  • Be responsible for the debt.
  • You should plan to pay back the debt, and you should anticipate repaying the credit.
  • Maintain a genuine debtor-creditor relationship.

For instance, if a relative proposes to provide you with funds to initiate a business and you later choose to return the gift with interest, this won't be considered. If you get a personal loan to buy things for your business, you can subtract the interest you pay.

Alternatively, let's say you secure an auto refinance loan for a car that you utilize for business purposes half of the time. You can deduct half of the interest on the loan.

Expenses on Investment Interest

The investment interest deduction is for the interest you pay when you borrow money to buy a qualifying investment. You can get a deduction if you have a brokerage account and borrow money to buy stocks. However, purchasing tax-favored municipal bonds is not eligible.

If you meet the criteria, the deduction is capped at your net investment income at your regular income tax rate. You have the option to roll over interest expenses if you are unable to claim the full deduction this year.

Second Home Loans

You can deduct interest payments on second home loans, like a home equity loan or home equity line of credit. Nonetheless, the mortgage value limit is applicable to the combined total of your primary and secondary home loans.

To be eligible, the loan proceeds must be used to significantly enhance the home by boosting its worth or prolonging its lifespan. In simpler terms, constructing an extension could be eligible, but aesthetic modifications that don't augment its value would not.

Conclusion

Keeping the possible tax implications in consideration, you can plan more tactically about the timing and reasons for obtaining a loan. Small-business owners can benefit from loans that qualify them for a deduction. They can help even if they only use part of the money for business expenses.

Remember, tax planning is year-round and essential to managing your personal finances. Many people frequently contemplate using their tax refund to reduce their debt. However, it might be more beneficial to utilize a more dependable source of funds, such as a personal loan.

Personal Loan Tax FAQs

Can the Interest on a Personal Loan Be Deducted from Taxes?

Generally, the interest on personal loans is not tax-deductible. Unless the loan is used for business expenses, qualified educational costs, or eligible taxable investments, you cannot deduct the interest expenses from an unsecured personal loan.

Can Loan Repayments Be Deducted from Taxes?

No, repayments on personal loans, car loans, and credit card debt are not eligible for tax deductions.

Which Personal Expenses Can Be Deducted from Taxes?

The primary personal expenditures that individuals can still deduct from their taxes encompass mortgage interest, interest on student loans, charitable contributions, medical expenses, contributions to 401(k) and IRA, and specific educational costs. The majority of these deductions are only applicable if you submit an itemized tax return.

Which Types of Interest Are Tax Deductible?

As per the IRS, the interest on the subsequent loans can be deducted from your taxes:

  • Home loan interest
  • Interest on unpaid student loans
  • Interest expenses on investments
  • Business loan interest
Photograph of author Joseph Priebe

Joseph Priebe

Joseph Priebe takes pride in assisting audiences with his articles to help them make sound financial decisions.

With over ten years of experience writing financial content his goal at CASH 1 has always been creating engaging and easy-to-digest information for anyone searching for immediate or long-term monetary solutions.

When Joseph is not writing about personal finance, you can find him photographing the Southwest United States with his 4x5 Graflex Crown Graphic camera. He is based in Phoenix, Arizona.