Personal loans are often not considered income and hence are not taxed. There are, however, some exceptions, such as when a lender forgives a portion of a loan or when a balance is settled for a lower amount than stated. Alternatively, they may have an effect on one's tax returns, depending on how funds are spent.
This article explores what constitutes taxable income and the implications for prospective borrowers.
Understanding Taxable Income
Taxable income is commonly defined as the earnings, salaries, freelancing income, tips, and bonuses received by an individual throughout a calendar year.
Certain types of income are not taxable, including:
- Benefits for accidents and personal injury.
- Maintenance and alimony.
- Child support obligations.
- Federal tax returns.
- Grants and subventions.
- Monetary gifts.
- Bursaries and scholarships.
- Veterans and social security benefits.
Additional tax implications may apply if a personal loan is obtained from a relative. For instance, where the loan is interest-free or has a rate lower than the current federal, the IRS might treat it as a gift rather than a loan. Either way, the money remains tax-free to the recipient.
However, it is important to note that monetary gifts have certain boundaries; if the donor's contribution exceeds the annual gift tax exclusion, an additional form may be required. Nonetheless, there is no requirement to document receipt of the gift. And the donor will not be taxed on the gift until it surpasses the lifetime gift tax exemption of $11.58 million.
Is a Loan Considered Income?
Generally, personal loans are tax-exempt. This is because the funds are not considered income since, unlike wage and investment income (which one earns and keeps), borrowed money must be repaid.
In the same manner, personal loans are not required to be reported on your tax filing. The same applies whether the loan was made via a bank, credit union, peer-to-peer lender, or any other financial institution.
The only exception is forgiven loans - A forgiven personal loan is money received by the taxpayer but never repaid. As such, it can be considered a source of income.
Cancellation of Debt (COD)
When a person is unable to repay an outstanding obligation, there are several options for getting the debt forgiven. Among them include talking with the lender, implementing debt settlement programs, and declaring bankruptcy.
When a lender agrees to cancel a debt, they will issue a COD and send a 1099-C form to the borrower. The latter must then record and submit the canceled amount to the IRS. However, these cases are rare.
In some circumstances, the forgiven loan amount is not required to be reported as income. If a private lender forgives the loan as a gift or if the lender forgives the debt in his or her will, the money is not required to be declared as income.
Additionally, pursuant to the Mortgage Debt Relief Act, which was enacted during the Great Recession, taxpayers are not required to pay taxes on forgiven mortgage debt up to $750,000. In view of the recent pandemic, the Consolidated Appropriations Act of 2020 extended these tax advantages for forgiven mortgages through 2025.
Is a Personal Loan Tax Deductible?
As a reminder, a tax-deductible expense is an amount that a taxpayer can deduct from their total gross income in order to minimize their tax liability. Personal loans often do not fall into this category. In other words, interest paid on personal loans cannot be deducted unless the funds are used for a couple of defined purposes and match the relevant qualifying restrictions.
The first exception is that part or all of the loan proceeds are being used for business expenses. It may be tax-deductible in this scenario. To get a personal loan for business purposes, the borrower must obtain prior approval.
Another possible exception is if the borrower contracts a personal loan and utilizes the entire amount to pay for qualified educational expenditures for him or herself, a partner, or a dependent.
One other distinction is the refinancing of a student loan with a personal loan. Interest payments up to $2,500 per year can be deducted in these scenarios. Mortgage interests may also be deducted.
Additionally, there is a write-off for investment interest if money is borrowed to purchase non-tax-exempt investments. For instance, if an individual takes out a loan to purchase stocks, the interest on the loan can be deducted. Only the amount of investment earnings in a given year may be deducted, but excess amounts may be carried forward to offset investment income earned in subsequent years.
Nonetheless, lenders offer a variety of personal loan products that can be used in all the above and more, such as auto loans, or mortgages. Prospective borrowers are encouraged to review all available options.
The Bottom Line
Personal loans, for the most part, do not impact taxes. These loans are not considered taxable income since the borrowed money must eventually be repaid. However, there are exceptions to this rule, such as in the case of forgiven loans which may be considered income and therefore taxable. Other special circumstances include obtaining loans from relatives at below-market interest rates, which could be treated as gifts for tax purposes.
Furthermore, certain personal loan interest expenses, such as those used for business purposes or qualified educational expenses, may be tax-deductible. However, it is essential to note that personal loans are generally not deductible unless the funds are used for specific defined purposes and meet relevant qualifying restrictions. Individuals with concerns regarding how their personal loans might affect their taxes are advised to consult a tax relief specialist, as personal situations can be complex and unique. Understanding these intricacies can help borrowers make informed decisions about their personal loans and tax implications.