Do Personal Loans Affect Your Tax Return?

Written by Peter Miller

Financial Expert

Edited by Kristin Marino

Managing Editor

If you’re considering a personal loan, you may be concerned about their effect on your taxes. Can you write off or deduct personal loans? Are personal loan proceeds considered taxable income? Most personal loans don’t affect most people’s taxes – but you should know the exceptions or face possible costs.

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Most Personal Loan Proceeds Are Not Taxable

Before we go further, let’s look at what a personal loan is.

There are many forms of loans – mortgages, auto financing, student loans, etc. A personal loan is unsecured, which means you don’t put up your house or car or any other asset when you borrow. It’s usually fixed, with an unchanging interest rate and payment, and comes with a predetermined term. Make your payments on time and in full over that term, and you know exactly when your loan will be repaid and how much it will cost.

The most important thing to remember about a personal loan and taxes is that it’s a loan. As long as you repay it, it’s not income and not taxable.

When Is a Loan Considered Income?

Generally, the money you borrow is not regarded as taxable “income.” However, there are situations where borrowed funds or low interest rates may create tax questions.

Loan Forgiveness

The IRS says that any amount of your loan that you fail to repay may be taxable income. This applies to any portion of your obligation that the creditor can’t collect or gives up on collecting and writes off. It may be related to a foreclosure, a repossession, giving property to the lender, abandoning the property, or a mortgage modification. Your creditor may send you a Form 1099-C, Cancellation of Debt (PDF) showing the amount of canceled debt.

Non-arms-length loans

Naturally, this being a tax issue, there are exceptions to the exceptions. For instance, a family loan for $10,000 or less can be forgiven and the forgiven amount may not be considered taxable income. It is, essentially, a tax-free gift. The same loan can also have an interest rate below the “applicable federal rate” (AFR) the IRS generally requires for commercial loans.

Imputed Income

In the usual case money from a personal loan is not taxable. However, there are situations where it might be. For example, imagine you get a $7,500 personal loan from a bank. You make no effort to repay the debt. The bank gets to write-off the $7,500 as a loss. It sends you a form 1099-C.

Does the government want people not repaying their loans? Does the government want to collect more taxes? Are loans taxable when borrowed money is not repaid?

Maybe.

There is some possibility that the government may look at that $7,500 in unpaid loan money and say it’s not “debt,” it’s “imputed income” and you have to pay taxes on the whole $7,500. Or, if you pay off $1,000 it might regard the remaining $6,500 as imputed income. Lastly, if the market rate for financing is 10% and you pay 5% the unpaid interest might also be seen as imputed income.

“The IRS,” says Alan Hale with the Summit CPA Group,”may impute interest on a loan at the ‘applicable federal rate’ (AFR) when a lower rate (or no interest) is charged. The agency then assesses tax on the excess of the imputed interest over the amount required by the terms of the loan.”

IRS Exceptions

The IRS doesn’t make you pay taxes every time a debt is forgiven. There is a healthy list of exceptions; for instance, your student loans might be discharged if you teach in a disadvantaged area. You don’t pay tax on that. Here’s the list:

1. Amounts canceled as gifts, bequests, devises, or inheritances
2. Certain qualified student loans canceled under the loan provisions that the loans would be canceled if you work for a certain period of time in certain professions for a broad class of employers
3. Certain other education loan repayment or loan forgiveness programs to help provide health services in certain areas.
4. Amounts of canceled debt that would be deductible if you, as a cash basis taxpayer, paid it
5. A qualified purchase price reduction given by the seller of property to the buyer
6. Any Pay-for-Performance Success Payments that reduce the principal balance of your home mortgage under the Home Affordable Modification Program
7. Amounts from student loans discharged on the account of death or total and permanent disability of the student

Bankruptcy

Unsecured debts discharged in bankruptcy are generally not taxable. Individuals who file Chapter 7 or Chapter 13 bankruptcies can generally wipe out some or all of their unsecured debts without incurring taxable income.

Are There Personal Loan Tax Benefits?

In recent years, the government has reduced the ability of individual taxpayers to write off interest in most situations. As an example, mortgage interest on a prime residence is generally deductible – at least in theory. In practice, under the 2017 Tax Cuts and Jobs Act, the standard deduction has become so large that few people take itemized deductions. According to the Tax Policy Center about 4% of all filers will take the mortgage interest write-off, far fewer than the 21% who took the deduction before the 2017 measure.

There are two considerations for personal loans.

First, the interest paid for personal loans is generally not deductible. Borrow $10,000 for a trip overseas and the interest cannot be written off.

Second, the interest for a personal loan might be deductible if the funds are used in a business, for investment, or for rental property. Purchasing a vehicle for business purposes qualifies, for instance. So does your personal loan to start an eBay business.

Get Professional Help

Naturally, any discussion regarding taxes is never straightforward or especially clear. Are loan funds taxable? What about a low interest rate? Does the source of the funds make a difference? What about how the money is used? Etc. Always check with a tax professional for exceptions, special situations, and general advice.

Finding the Best Personal Loan

Where do you find the best personal loan? You have to shop around. Speak with banks and credit unions as well as family and friends. Be aware that friends and family may offer better rates and terms but there may be a significant cost in terms of personal dynamics.

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