Taking out a personal loan can be a useful way to cover all manner of fees and expenses, but how does the Internal Revenue Service (IRS) view the money that you borrow, and do personal loans affect your tax return? Read on to find out what you may - or may not - need to do, as you sit down with your tax software.
What is a personal loan?
A personal loan is a lump sum of money that you’re able to borrow from a lender on the promise that you’ll pay it back, usually with interest. You’ll have a repayment schedule whereby you repay a set amount each month, and at the end of the term, the loan (plus any associated interest) will be paid back and your obligations to the lender come to an end.
Is a personal loan taxable?
Typically speaking, no, a personal loan is not taxable. This is because a loan generally isn’t viewed as income by the IRS – you’re not earning anything from it, as you would with wages or investment earnings, and as you have to pay it back your net worth won’t increase, which means it has no bearing on your tax status and won’t need to be declared.
This is the case no matter where you borrow the money from, be it a bank, peer-to-peer lender, credit union or any other financial institution. Even if the loan is from a family member or friend, the money won’t be classed as taxable income; it may even be considered a gift rather than a loan if it has no or below-market rate interest, though the giver may need to file an extra form if the gift exceeds their yearly gift tax exclusion (which is $15,000 for calendar year 2021).
The exception to the rule is if part of your loan is canceled by the lender, and/or you settle the remainder for less than you actually owe. In this case, the canceled or forgiven portion is considered income; you’re benefiting from the extra money as you won’t need to repay it, and it will therefore become taxable. As such, it will need reporting to the IRS, and could have an impact on your tax liability.
This can also apply in the case of certain federal student loans that are forgiven after you’ve made payments for 20 or 25 years, as well as with secured loans that have been canceled and the lender claims the secured property as payment. If the loan contract is for recourse debt, you’ll need to report the difference between what you owe and the market value of the property claimed as taxable income. If it’s for nonrecourse debt – in other words, you’re not held personally liable for it – the claimed property is considered sufficient payment, and the canceled amount doesn’t need to be reported.
All that said, there are exceptions to the exceptions! If the debt is discharged during bankruptcy or insolvency, the forgiven loan may not count towards your gross income, and therefore won’t be taxed. Similarly, some student loans can be forgiven without the remaining amount being considered taxable. If you’re filing your taxes for 2021 and think some of these exclusions apply, it’s worth consulting a tax professional to go over things.
Is the interest on a personal loan tax-deductible?
Unlike with some types of loans – such as mortgages, student loans or business loans – the interest payments on personal loans are not tax-deductible, meaning you can’t use the interest to reduce your income for tax purposes.
However, there are a few scenarios in which you can deduct the interest payments, such as if some or all of the money loaned to you is used for business purposes, if you use it for a qualified educational expense, or if you take out a loan to buy stocks or similar investments. You’ll need to check with the lender if you can use the loan for these kinds of purposes though, as not all do.
Do I need to declare a personal loan on my tax return?
Only in one of the exceptions listed above. If a portion of your loan is canceled or forgiven, you may be sent Form 1099-C by the lender, which will detail the amount of canceled debt you’ll be required to report on your tax return as regular income. Similarly, if you meet the criteria to deduct interest payments, you’ll need to declare it accordingly. In these kinds of exceptional circumstances it’ll be prudent to consult the experts who will be able to help you determine what needs to be reported, and with the tax season starting February 12 this year, now could be the time to find that kind of support.
Yet the majority of the time, personal loans aren’t taxable and nor is the interest tax-deductible, which means it won’t have any impact on your tax return and you won’t have to report any loans you take out. Provided you manage the loan efficiently, don’t miss any repayments and are able to repay the amount in full by the required date, there’ll be nothing whatsoever to declare, and you can file your return in confidence.