Are Tax Deductions Applicable to Personal Loans?

Personal loans are typically utilised to finance a large purchase like house or cars, fund a big event like a wedding ceremony, or consolidate high-interesting debts. They’re offered through P2P or peer-to-peer lending networks, employers, or banks. 

In today’s market, personal loans are among the cream of the crop. Just between Q3 2018 and Q3 2019, the total amount of both secured and unsecured loans skyrocketed from 20.3 million to 22.5 million. 

While the said increase seems like a big development, personal loans only make up around 2% of the overall consumer debt in the United States. One reason for this is that some (or many) borrowers might not know how personal loans work and how the Internal Revenue Service (IRS) deals with them.

Whether personal loans are tax-deductible or not is one of the questions that many borrowers are confused at. If you’re one of them, we’ve got you covered. In this article, we’ve curated crucial information about the tax implications of personal loans. 

Tax Liability for Personal Loans

A tax deduction or allowable deduction, as the terms imply, is an expense that can be reduced from a person or married couple’s gross income to lessen the amount of money that is subject to a tax. Take note that only “taxable income” can be tax-deductible. 

Personal loans are typically not considered taxable income. Your repayments for these loans aren’t tax-deductible. Say, you borrow a sum of money through a personal loan to finance your wedding ceremony or cover other personal expenses. The interest payments you pay for this loan, be it secure or unsecured, do not reduce your tax liability. 

Tax-deductible Personal Loans 

The thing is, if you use a personal loan to fund your schooling, company launching or expansion, and home improvement, the interest you’ll pay can be tax-deductible. Check them out here:

Mortgages and Home Equity Loans
Mortgages and home equity loans are only tax-deductible if funds borrowed are utilized to finance building, renovating, or buying a property. 

For example, for married taxpayers who are filing a joint return, you may be able to take off interest on the first $750,000 of your first or second mortgage. Alternatively, if you’re planning to file a separate return, you can subtract interest on the first  $350,000.

Business Loans
If you’re a business owner who is using a personal loan for your business, you can also deduct the total of the interest payments. However, only the percentage of the amount used to finance your business is tax-deductible. 

Student Loans

Paying off student loans has been one of the financial crises of many American citizens, including those who already graduated, settled down, and been working for years. 

The good thing is student loans can now be deducted for about  $2,500 in interest annually. However, they’re only tax-deductible if you’ve taken out the loan from a qualified lender, such as the credit or cash ninja. 

Private personal loans, especially from friends, friends, or colleagues, aren’t deductible. However, if you are the one lending the money to someone else, the IRS can “potentially” treat the interest payments you will receive as taxable. To avoid being dinged by the IRS, you need to get the borrower’s Social Security number and income and file Form 1099-INT. 

Other Exceptions: Loan Forgiveness and COD

Loan forgiveness or cancellation of debt (COD) are two ways to be off the hook in paying taxes for your outstanding balances. 

Loan Forgiveness 

If your loan is forgiven, you don’t have to pay for the taxes of the amount that’s less than your liabilities that are subtracted by your assets. That’s why loan forgiveness is often considered as a form of a gift. 

Cancellation of Debt (DOD)
If your loan is canceled, your lender doesn’t expect and require you to repay the remaining balances or the loan’s principal. It seems like the loan becomes the income that’s given to you by the lender.

Then, your lender might send a form called Form 1099-C, which you have to hand into the IRS. You’ll typically get this form after the abandonment of property, foreclosure, modification of a loan on your principal residence, property return, and repossession. This document will prove that your loan’s interest is now a cancellation of debt (COD) income, which is taxable.

If a percentage of your personal loan is forgiven or canceled, lenders will no longer expect you to repay your outstanding balance. Hence, the IRS will consider the loan balance as income, which can eventually become tax-deductible.

Takeaway

Personal loans aren’t considered as taxable income because they’re “loans” and must be repaid in the first place. There are exceptions, though. Some personal loans utilized for expenses like investments, business expenses, and qualified education expenses are tax-deductible.