A summer wedding. A fall vacation. If you’re a homeowner, a winter of gift exchanges and a few small home renovations These are all good justifications for getting a personal loan.
Taxes can be, well. one of the most difficult aspects of personal finance, particularly when confronted with a novel financial situation, such as a personal loan Follow along as we discover more about personal loans and how they impact taxes.
Can a Personal Loan Interest Deduction Be Claimed on Taxes?
When taking out a loan for personal use, there are some exceptions to the general rule that personal loan interest is not tax deductible.
If some or all of the interest can be connected to the following kinds of loans, you might be able to deduct personal loan interest from your taxes:
We’ll cover these exceptions more in just a bit. Let’s define what it means to claim interest on your taxes first, though.
Meet James. James works hard. In fact, James made $75k in the previous fiscal year before taxes.
Like all outstanding citizens, James is a taxpayer so James is getting ready to file his taxes for his latest tax year. He knows that the Internal Revenue Service calculates taxes as a percentage of his income. So he starts crunching the numbers based on his cool 75K.
But wait, James! Don’t you know about deductions? A tax deduction is a reduction of taxable income. You can qualify for a dedication if you’re married, have children, make charitable donations, contribute to an IRA account, install energy efficient appliances, or even when shopping for clarinets (see for yourself). Another common standard deduction is interest paid on loans.
After deducting his expenses, James’ taxable income is reduced to $55,000. And all those extra clarinet lessons are paid for by those income tax savings!
So, What Types of Personal Loan Interest are Tax Deductible?
Let’s get back to personal loans. Similar to mortgage loans, auto loans, and credit cards, personal loans often have an interest rate built into their repayment schedule. But typically, only homeowners can deduct interest, since mortgage interest qualifies for a tax deduction.
Generally speaking, interest on loans for personal use, including credit card debt, auto loans, and home equity loans, is NOT tax deductible. Check to see if you qualify for any of the following three personal loan exceptions before filing your tax return, though:
☑️ Using a Personal Loan for Business Purposes
Business loans aren’t always easy to get, especially if you’re self-employed. If you use any of your personal loan funds to form or run your small business, the associated paid interest can be deducted when you file your personal taxes. Website development, purchasing inventory, and marketing can all qualify as business expenses (FYI, if your small business files taxes, you cannot claim business expenses on both your personal AND business tax forms).
☑️ Using a Personal Loan for Qualified Higher Education Expenses
One in eight Americans have student loan debt. While these loans are one option for tackling the high cost of further education, funds from a personal loan can also be used to pay for college tuition, fees, and associated activity costs. This means that interest payments on a personal loan used to manage certain education expenses, including student loan interest, may be deductible.
☑️ Using a Personal Loan for Taxable Investments
If you use the money from your loan to invest in stocks, mutual funds, or bonds, you may be able to deduct any paid interest on your taxable investments. But keep in mind there may be tax implications in the form of short-term or long-term capital gains and you’ll need to itemize your deductions to take advantage of this deduction, which isn’t common.
Examples of Deducting Personal Loan Interest from Taxes
Let’s speak with James to observe these exceptions in action. Did you know that he obtained a $10,000 personal loan in total?
He used $2,000 to buy new equipment for his business. Then, he spent $3,000 on his college expenses (way to go, James, for being both a business owner and a student!). Then he put $1,000 into the stock market, buying shares of a real estate firm, a few tech companies, and some ETFs. James works hard and plays hard, so he used the remaining $4,000 for personal expenses, particularly a fantastic Caribbean vacation.
James may be able to receive tax benefits and deduct any interest paid on this loan.
He should consult a reputable tax expert for assistance with the specifics, but he can probably deduct the interest paid on the loan amounts that covered his educational costs and business expenses. He might be able to claim the interest paid on the amount used to purchase the stocks as a deduction, but this will be more challenging because it needs to be an itemized deduction. He won’t be able to deduct the portion of the loan that was used to fund his getaway because it was a personal expense, so he will have to make do with a tan.
Uncle Sam has no interest in the interest on these types of loans
You don’t have to disclose to the IRS all of your monthly loan payments. They don’t care, but the interest on, say, a debt consolidation loan cannot be written off because a bank loan is not regarded as income.
The same goes for credit cards. If your credit limit has been reached, you’re probably paying significant interest charges. But there are no tax credits for credit card debt. Therefore, improving your credit score or refinancing through a balance transfer are your best options if you want to reduce your credit card interest costs.
Are Personal Loans Considered Taxable Income?
We know what you’re thinking. Are you really saving anything by claiming the interest on personal loans as a deduction if they are included in your taxable income?
This could be a valid point—except personal loans are not considered taxable income. Taxable income is defined as money you earn after deductions from your adjusted gross income (AGI), primarily received through either a job or investments. Similarly to a personal line of credit, personal loans are funds received with an intent to pay back, so they do not increase the borrower’s taxable income. This helps us understand why personal loan interest is not tax deductible.
What Happens if Your Personal Loan is Canceled?
Come tax season, you’ll need to take a few extra steps if you took out a personal loan and later fell behind on your payments.
Upon default, your lender may issue you a cancellation of debt, or COD, depending on your lender. Following that, you’ll get a 1099-C tax form that must be included with your return and sent to the IRS.
While a loan in good standing doesn’t count as taxable income, unpaid and canceled debt does. Here’s why.
If there are no origination fees or exorbitant interest rates, your bank account is neutral when you borrow a dollar and return it. However, if you borrow $1 but only pay back $50, you effectively make a $2 profit. Unreturned loans, in contrast to personal loans with good standing, are considered income by the IRS and are taxed as such.
By the way, taxes are difficult, and you shouldn’t be careless with your personal finances. For accurate tax liability purposes, we advise that you always consult with a reputable tax expert (James does this when it comes to deducting personal loan interest).
Never assume that the interest you pay on a personal loan will be tax deductible. At the same time, being aware of when interest on personal loans can be deducted will help you avoid paying Uncle Sam more than necessary.
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