If you’re wondering about the tax implications of personal loans, you’ve come to the right place. Whether you’re borrowing from a personal loan lender, funding a loan to a family member, or seeking personal loan forgiveness, the IRS has rules that are important to understand. Here’s what you need to know.
Are personal loans tax deductible?
In general, interest you pay on personal loans is not tax deductible if used for most personal reasons. Meaning, you can’t typically use a personal loan to reduce what you owe on tax day. But there are some exceptions. If you use a loan for business expenses, taxable investments, or higher education expenses, you may be able to deduct the interest up to certain limits. If you use only a portion of the loan funds for business purposes, you can typically deduct that share of the interest.
For example, if you use the loan to start a small business, buy a rental property, or pay for your textbooks, the interest on the money you borrow may be tax deductible up to a certain amount. But you should make sure the lender you choose allows the loan to be used for these purposes. For instance, many personal loan lenders do not let you use loans to pay for education or business purposes.
If you’re considering deducting personal loan interest on your tax return or taking out a personal loan for a potentially tax-deductible purpose, it’s crucial to consult with a tax professional. They can help make sure you’re following the rules and keeping adequate records.
Tax implications if your personal loan is forgiven or canceled
If your debt is canceled, forgiven, or discharged, it’s generally taxable as income for that year. Your creditor will likely provide you with a Form 1099-C showing the date of the cancellation and the amount. You’ll report the canceled debt on Form 1040, and it will be taxed as ordinary income, according to your tax bracket. However, there are exceptions to this rule.
Exceptions to the tax rules
There are certain scenarios that allow you to exclude forgiven debt from your gross (pretax) income. For example, if your personal loan debt was canceled in a Title 11 bankruptcy filing, or if you are insolvent, you may not need to include the forgiven amount on your tax return. You are considered insolvent when your total debts exceed your total assets.
Are personal loans treated as taxable income?
The answer depends on whether you’re the recipient of the loan or you’re the one extending it. Unlike employee compensation, benefits, and investment income, the IRS doesn’t consider personal loan funds you receive to be income. (This is because you have to pay them back.) So, you won’t have to pay income tax on your loan proceeds.
However, if you’re providing the loan and receiving interest payments, you’ll need to pay taxes on the income you receive from the loan. For example, if you charge interest on a peer-to-peer or family loan, the interest you receive is considered taxable income.
And if the loan is more than $10,000, or the recipient invests the money, you’re required to charge them interest that’s at least the applicable federal rate published by the IRS. If you issue a loan with a below-market interest rate, you may still be required to pay taxes on the interest you would have received had you charged the applicable rate (that interest is called “forgone interest”).
However, if the gift loan is less than $100,000, the IRS only requires you to pay forgone interest if the recipient’s net investment income is greater than $1,000. If it is, the forgone interest you’ll pay is limited to the recipient’s net investment income for the year. That said, the limit doesn’t apply if the loan is used mainly to avoid taxes. Since the rules are tricky, it’s best to discuss your situation with a tax professional.
Gift taxes and personal loans
If you elect to give someone a cash gift rather than a loan, it’s important to understand that the gift may be considered taxable. The IRS may also treat a loan as a gift if it is provided interest-free or at a reduced rate. However, the following are not considered taxable gifts:
- Gifts that don’t exceed the annual exclusion ($17,000 for 2023)
- Gifts of tuition or medical expenses
- Gifts to your spouse (if they are a U.S. citizen)
- Gifts to political organizations, charities and certain exempt organizations
You and your spouse can each give up to $17,000 in 2023 to as many recipients as you want without tax implications. Even if you exceed that amount and the gift is considered taxable, you’ll only begin paying taxes once you exceed your lifetime exemption amount, which is $12.92 million for 2023. This exemption covers both gifts and estate tax.
For example, if you give each of your two children $25,000 in 2023, you’ll have used $16,000 of your $12.92 million lifetime exemption. That’s $8,000 per child in excess of the annual exclusion.
FAQ
When is the interest on a personal loan tax deductible?
Personal loan interest is only tax deductible if the loan is used for business expenses, higher education expenses, or taxable investments. But lenders frequently do not allow borrowers to use loans for these purposes.
How do I report taxable interest from a personal loan?
If you issued a loan and received taxable interest, you’ll need to report the amount on Form 1040. If your interest income is more than $1,500, you’ll also need to prepare Schedule B along with Form 1040.
Are P2P lending taxes capital gains?
Interest from a loan you issued on a peer-to-peer lending platform is considered taxable as ordinary income. You’ll pay your regular income tax rate on the earnings, which depends on your tax bracket.
