Taking out a personal loan is one way to access funds for a variety of purposes, from consolidating high-interest debt to financing a large purchase. However, one downside to personal loans is that the interest you pay is not tax deductible in most cases.
When Personal Loan Interest Is Tax Deductible
While personal loan interest is generally not tax deductible, there are a few exceptions:
Business Expenses
If you take out a personal loan and use the proceeds for legitimate business expenses, the interest may be tax deductible. For example, if you take out a personal loan to purchase inventory for your small business or to expand your home office, the interest would qualify as a business expense.
To claim the deduction, the loan proceeds must be used 100% for business purposes. If you use any part of the loan for personal reasons, that portion of the interest is not deductible. You would deduct the business loan interest on Schedule C of your tax return.
Educational Expenses
Interest paid on a personal loan used for certain qualifying education expenses may be deductible. This includes loans used to pay for tuition, fees, books, supplies, and equipment required for enrollment at an eligible educational institution.
To qualify for the student loan interest deduction, the loan must be taken out solely to pay education expenses for yourself, your spouse, or your dependent. Income limits apply, and the maximum deduction is $2,500 per year.
Investments
If you take out a personal loan to purchase taxable investments like stocks, bonds, or mutual funds, the interest may qualify for the investment interest expense deduction. To claim this deduction, you must itemize deductions on Schedule A.
There are limitations, such as not being able to deduct more than your net investment income. Any excess interest can be carried forward to future tax years.
When Personal Loan Interest Is Not Deductible
In most other cases, the interest paid on a personal loan is not tax deductible. Here are some examples of personal loans with non-deductible interest:
- Debt consolidation loans
- Loans for home improvements or renovations
- Loans to purchase a vehicle
- Loans for medical expenses
- Loans for a vacation or other personal reasons
The interest paid on these types of personal loans cannot be deducted on your tax return. If the loan is used for both personal and business purposes, only the portion of interest that relates to the business use may qualify for a tax deduction.
Itemizing Deductions
To deduct interest paid on a personal loan, whether for business, education, or investments, you must itemize deductions on Schedule A of your Form 1040.
If you claim the standard deduction, you cannot deduct any interest expenses from your personal loan. Itemizing deductions only makes sense if your total itemized deductions exceed the standard deduction amount for your filing status.
Recordkeeping Requirements
To deduct personal loan interest, meticulous recordkeeping is required. You’ll need to show the IRS:
- Loan origination documentation showing the loan amount and loan date
- Records proving how the loan proceeds were used
- Account statements or loan interest reports documenting interest paid
- Receipts, invoices, or other documentation if the loan was used for educational or business purposes
Without proper documentation, your deduction could be rejected if the IRS is unable to verify that your loan interest qualifies as deductible. Keep these records for at least 3 years after deducting the interest expense.
Income Limits
Certain deductions for personal loan interest, such as the student loan interest deduction, are only available to taxpayers below specified income limits. If your income exceeds the threshold based on your tax filing status, you cannot claim the deduction.
These income-based limits do not apply to interest deductions for business or investment loans. However, be aware that high-income taxpayers may be subject to other deduction limitations.
Talk to a Tax Professional
The rules surrounding deducting personal loan interest can be complex. Before claiming deductions, consult a qualified tax professional who can evaluate your specific situation.
An accountant or tax attorney can guide you on what loan interest expenses you may be able to deduct. They can also explain recordkeeping requirements and any other deductions you may qualify for.
Proper tax planning can help maximize your deductions and reduce your tax bill each year. Just be sure to abide by the tax code—the IRS scrutinizes taxpayers claiming sizable interest deductions.
The Bottom Line
Very few taxpayers are able to deduct interest paid on personal loans. Work with a tax pro to determine if your circumstances permit you to deduct loan interest before filing your tax return.
Proper documentation is imperative if deducting personal loan interest, as is using the loan solely for approved purposes. While not common, deducting personal loan interest in specific situations may provide substantial tax savings each year.
FAQ
What type of loan is tax deductible?
Other types of loans are tax deductible even though personal loans are not. Mortgage, student, and business loan interest is frequently deductible on your yearly taxes, effectively lowering your taxable income for the year.
Does the IRS care about personal loans?
The IRS defines income as money you make, whether from a job or investments. Personal loans have repayment obligations, and unless they are forgiven, they cannot be considered income. You do not need to worry about reporting your personal loan on your income taxes if you do not intend to seek debt cancellation for it.