Understanding Tax Deduction on Personal Loans

When tax season rolls around, it usually means collecting all your documentation related to income, expenses, and assets. Many different types of loans have tax implications, but what about personal loans?

Are personal loans considered income?

For the most part, personal loans are not considered taxable income and therefore are not reported on federal income tax returns. However, there are exceptions, when the lender cancels or forgives your debt, or a portion of your debt, then the amount forgiven will be reported as taxable income.

While personal loan funds increase your bank account balance and can be used similarly to your income, they are not the same. Income is money that a person earns, such as wages or investment revenue, while a personal loan is a debt that a borrower repays.

Borrowers can acquire personal loans through credit unions, banks, and online lenders. Personal loans can be used for expenses, including home improvement, debt consolidation, and unexpected bills. They can be unsecured, based primarily on a borrower’s credit history for approval, or secured, requiring borrowers to have collateral as a stipulation to borrow.

What happens if a personal loan lender cancels or forgives your loan?

While personal loans are considered debt and not taxable income, that can change if your lender cancels or forgives your debt.

If you fail to repay a loan and a lender forgives the remaining balance, it is likely considered cancellation of debt (COD) income. The forgiven balance of the loan can also be taxable if a creditor is unable to collect the debt. For example, if a borrower took out a personal loan for $3,000, and failed to pay back $1,000, the balance due would qualify as taxable income.

“Personal loan forgiveness is almost always considered to be taxable income,” says Elizabeth Buffardi, CPA, CFP, President of Crescendo Financial Planners. Talk with a tax or legal representative to see if your discharged debt is considered taxable income.

There are a few exceptions where the borrower wouldn’t have to pay taxes on the discharged debt.

1. Bankruptcy

Debts that are discharged during bankruptcy proceedings aren’t considered taxable. This can include Chapter 7 bankruptcy and Chapter 11 bankruptcy, according to the IRS.

2. Federal government intervention

In certain circumstances, the federal government has allowed forgiven debts to be exempt from taxation. Businesses that received a Paycheck Protection Program Loan (PPP) during the pandemic may qualify for forgiveness that wouldn’t be considered taxable income. Other legislation like the Consolidated Appropriations Act (CAA) extended the exclusion of mortgage debt from taxation for qualified homeowners.

“Legislation can specify that forgiven loans are not income, such as what was done in 2020 for the PPP loans with the CARES Act and in the past for homeowners with underwater mortgage loans,” says Sallie Mullins Thompson, CPA, CFP, and CDFA.

3. Insolvency

If a borrower is insolvent, meaning their debts exceed their income and they are unable to pay their bills, they may be exempted from paying taxes on their forgiven debt. The borrower’s liabilities would have to be more than their assets at the time the debt is discharged.

How do you know if your debt has been canceled?

When a debt is canceled, in this case, a personal loan, the lender may issue a Form 1099-C Cancellation of Debt. Borrowers may receive this form after a creditor discharges a debt of $600 or more. Borrowers may also receive a Form 1099-C due to repossession and foreclosure. This Internal Revenue Service (IRS) form details information such as:

• The amount of canceled debt
• Date of cancellation
• Creditor’s and debtor’s contact information
• Interest

The IRS requires that a borrower report canceled debt on their federal income tax return the year the cancellation occurs. Even if a borrower does not receive the cancellation of debt form because the debt discharged was less than $600, they are still responsible for reporting the amount on their tax return. If you have any questions about your debt cancellation, reach out to your tax or legal representative.

Are interest payments or repayments on personal loans tax deductible?

The answer: It depends.

Interest is the cost borrowers incur to borrow money. It may be deductible or claimed as a credit on your taxes, depending on how the loan was used. Interest on student loans, mortgages, and business loans can be tax-deductible.

However, repayments on personal loans and interest payments are not typically considered tax-deductible. Generally, when a loan is used for personal expenses, it does not decrease your tax liability.

“Principal repayments are not tax-deductible since the loan proceeds are not income taxable nor reported on income tax returns,” Mullins Thompson says.

Is personal loan interest tax deductible?

The interest you pay on car loans, credit cards, or unsecured personal loans are not tax deductible but there may be exceptions if you use the loans for:

• Mortgages
• Higher education expenses
• Business purposes

There are many different types of personal loans, and it may not be clear which loan repayments qualify for a tax deduction. For example:

“If you took out a loan to consolidate credit card debt or to get a lower interest rate, then that loan interest is not deductible,” Buffardi says. “However, if you used a loan to buy inventory for your business and you can clearly show that the loan proceeds went to pay for the inventory, then that interest would be deductible.”

Discuss the following types of loans with your tax representative to see if you can take a deduction on your taxes:

1. Mortgages

Mortgage interest may be tax-deductible on Form 1040, Schedule A. The taxpayer must meet certain qualifications specified by the IRS to take advantage of this tax benefit.

2. Student Loans

When people need money for higher education, they usually think of federal and private student loans first and not personal loans. Federal student loans have multiple advantages, including low interest rates, longer repayment terms, and no credit check required. Private student loans can also be used to help cover education costs, but these types of loans do not have the advantages of a federal student loan.

What borrowers may not realize is they may be able to use a personal loan for qualified education expenses, such as college tuition or activity fees, or refinancing a student loan, and the interest payments could qualify as a student loan interest deduction. However, before you go down the path of using a personal loan for educational expenses, check with the lender to confirm if it is allowed since some lenders prohibit using the funds for higher education costs.

There are income limitations and other rules set by the IRS for claiming the interest. For example, you can't claim it if you are married and file separately from your spouse.

For federal student loans, borrowers may be able to deduct up to $2,500 on their tax return, depending on their adjusted gross income. To take advantage of this benefit, the borrower must have an adjusted gross income of under $70,000 as a single person or under $140,000 as a married couple filing jointly (if the borrower’s adjusted gross income was between $70,000 and $85,000, or between $140,000 and $170,000 if filing jointly, they may deduct less than $2,500). Borrowers who paid more than $600 in interest for the year and qualify for this deduction should expect to receive a Form 1098-E from their student loan servicer.

3. Business purposes

There are many expenses associated with starting a new business, even if it's a side hustle or part-time gig. You may need a new computer, office space, equipment, and supplies to get started. Many new business owners rely on loans to fund their startup costs. While you can take out a business loan specifically for this purpose, you can also borrow money with an unsecured personal loan. You can use a personal loan for business purposes and the interest associated with the portion used for your business expenses is tax deductible.

The good news is your business doesn't have to be considered large or need multiple employees to receive the benefit of a tax deduction. A business loan or personal loan can be used towards expenses associated with small operations, including side hustles, freelance, or consulting work.

Borrowers who use part of a personal loan for business expenses can deduct a portion of the interest. However, the borrower will need to meet the criteria set by the IRS.

Why understanding a tax deduction on a personal loan matters

There are numerous advantages to unsecured personal loans. You can use them for a variety of purposes, from providing much-needed repairs to your home to covering an unexpected bill. The funding is typically fast, and you receive one lump sum to use as you need. Once your payments begin, you have one fixed monthly payment for a specified time period. However, the lender charges interest, so the longer you take to repay your loan the more you'll pay in interest over time.

If you need a personal loan, the first question to ask yourself is how you will use the funds. There are loans where the interest is tax deductible, including student loans, business loans, and mortgages; if you itemize your deductions. If your needs for an unsecured personal loan fall into one of these three categories, then it may make more financial sense to explore borrowing with one of these loans versus a personal loan, so you can reap the benefit of the tax deduction.

Keep in mind you shouldn't rely on a tax break to be able to afford the repayment of a loan. If you evaluate your monthly payment amount for a personal loan (or another type of loan) and it puts too much strain on your budget, then you should consider an alternative, if possible. There may be other affordable borrowing options available, such as a low-interest credit card or personal line of credit. As with any borrowing decision, compare all available options to ensure you're getting the best interest rate and repayment terms for your personal financial situation at a rate you can afford.

The bottom line

For most people, a personal loan won’t have significant implications when tax time rolls around. Personal loans are not considered taxable income and the interest isn’t considered tax-deductible. If the borrower repays the loan, they probably will not need to report it on their taxes, with a few exceptions. Thankfully, qualified tax professionals and legal representatives can guide borrowers who have questions about their situation.

Sallie Mullins Thompson is a CPA financial planner, CFP, Certified Divorce Financial Analyst (CDFA), and tax strategist, with over two decades of experience in the financial services industry. She assists families, business owners, and individuals, in the NYC and Washington, DC metropolitan areas, with all elements of their financial lives, from tax to investments to savings to planning to life transitions.

Elizabeth Buffardi, CFP, CPA, is the Founder and President of Crescendo Financial Planners in Oak Brook, Illinois. She is also a certified member of Alliance of Comprehensive Planners, a group of holistic financial planners that are tax focused and adhere to the Fiduciary Standard. You can learn more about ACP and search for advisors at www.acplanners.org.