Can A Personal Loan Affect Your Taxes?

A personal loan provides you with a lump sum from the bank when the loan closes. But, since you pay taxes on any income you earn, you may wonder, do you have to pay personal loan taxes?

The answer is “maybe not,” because it depends on the situation of the loan and the reason you’re borrowing the money.

What Is A Personal Loan?

A personal loan is an unsecured loan you can borrow to use how you see fit. Whether you need money for home improvements, debt consolidation, to pay for a wedding or another significant expense, you don’t have to get the reason approved.

Also, you don’t have to put up collateral.

Do You Pay Taxes On Personal Loans?

You receive the money as one lump sum, so do you pay taxes on personal loans as you would on other income?

No, because the Internal Revenue Service (IRS) doesn’t consider the money received from the personal loan to be taxable income. You just borrow the money but must pay it back with your earned income which you pay taxes on already.

How much you pay in taxes depends on your federal income tax bracket. The more money you make (not borrow), the higher your tax bracket, which means you pay more taxes on your tax return. The tax brackets vary from 10% to 37%, depending on your income.

Are Personal Loans Ever Taxable?

The IRS doesn’t consider a loan taxable income. But, if your lender forgives or cancels more than $600 of your loan, the loan amount you received could be subject to income tax. Usually, cancellation of debt (COD) happens if a borrower is in financial trouble and negotiates for debt relief.

If you have canceled debt during the tax year, you’ll receive IRS Form 1099-C, which shows how much the lender wrote off so you can add it to your taxable income.

Are There Exceptions To Taxing Loan Forgiveness?

According to the IRS, there are some situations where you might not have to pay taxes on canceled debts. Most apply to other types of loans, like higher education loans and student loan repayment programs.

But if a lender (in this case, usually a private individual, like a parent or friend) cancels a loan as a gift, it may not be taxable income. Also, debt canceled by bankruptcy isn’t part of a taxpayer’s gross income.

Is Personal Loan Interest Tax Deductible?

Most uses of personal loans aren’t tax deductible because borrowers can use the loan proceeds as they see fit. However, there are a few rare instances when you can deduct interest payments made on a personal loan.

Business Purposes

If you use the money for business expenses, you may be able to write off the interest on your taxes. First, you must ensure the creditor allows you to use funds from a personal loan for business use. Be sure to note these expenses as itemized deductions on your tax return.

Educational Expenses

If you use the money to cover qualified educational expenses or to pay off student loans, you may qualify to write off up to $2,500 in interest per year. Before you take out a personal loan for educational expenses, make sure the lender allows it for this use.

Taxable Investments

The final way to deduct personal loan interest is if you use the money to invest in taxable investments. This doesn’t apply if you use your retirement account to buy stocks or bonds in a regular investment account. In addition, you can roll over unused interest deductions.

Can You Use A Personal Loan To Pay Your Taxes?

If you have a large tax bill that you can’t afford to pay, you can take out a personal loan to pay your taxes. You may get a lower interest rate on a personal loan that costs you less than the penalties the IRS would charge.

If you don’t qualify for a personal loan or don’t want another loan, you have a few other options, including charging the debt. However, credit card interest rates are usually higher than personal loan interest rates, so compare your costs.

You can also work with the IRS on a short-term repayment plan that gives you 180 days to pay the total bill. Or you can set up a long-term payment plan that breaks up your payments over a longer period. Remember, though, that the IRS still charges interest and penalties when you are in a payment arrangement.

While an IRS payment plan doesn’t hurt your credit score, using a personal loan or credit card may affect your score.

The Bottom Line

You can use a personal loan for many uses, and most people won’t pay taxes on the money borrowed. Of course, if you default on the loan, you’re likely to owe taxes. Otherwise, it’s tax-free money.