When you take out a personal loan, you receive a lump sum of money to spend as you see fit. Is that pile of money ever taxable?
This question could become commonplace as the popularity of personal loans is expected to explode this year. The TransUnion credit bureau predicts that borrowing for personal loans in the spring quarter (April, May, and June) will be up a staggering 62.3 percent over last year.
If you have a personal loan, you generally don’t have to worry about it when you file your taxes. But there are a few instances where things can get a little more complicated.
First of all, what is a personal loan?
Personal loans are a great solution when you need cash for large expense as wedding, unexpected medical bill or a home repair project.
Loans are typically unsecured debt, which means you don’t have to provide any collateral. Personal loans can be used for anything. They can be a lifesaver for emergency expenses, and they’re useful for consolidating debt. You can consolidate expensive credit card balances into a personal loan at a lower interest rate to pay off the debt faster and more affordably. Generally, you borrow a fixed amount of money at a fixed interest rate, and you have a deadline to pay the money back.
Interest rates vary by lender and depend on factors such as your credit rating.
Are the proceeds of a personal loan considered income for tax purposes?
A loan is money you borrow and are expected to be paid back – so no, it is not considered an income. Loans are generally not taxable because the IRS is primarily interested in the money you earn and keep
This remains the case as long as you are in good standing with your loan and pay your debt on time and in full.
But if you fall behind on your payments or stop making them, the answer to the tax question may be different.
When a personal loan can trigger taxes
If your income or circumstances change and you can no longer keep up with your loan payments, you may default on your debt – and some or all of it may be forgiven, either through bankruptcy or if you work with a credit management agency.
In the event of cancellation, your lender will give you a 1099-c form, which you must attach to your tax return to show the amount of debt canceled.
The IRS is interested in this because when you don’t pay back the borrowed money, you are no longer borrowing it, but receiving it as income in the eyes of the tax authorities.
Let’s say you borrowed $20,000 and managed to pay back half of it before you stopped paying back your loan. If you never intend to pay back the remaining $10,000, the IRS will expect you to report it as income on your tax return – and pay taxes on it.
The case of personal loans that are truly personal
There’s another case where a personal loan can have tax consequences, and that’s when the loan is truly personal, i.e., when it’s made between friends or family members.
If you give someone a “loan” with no interest or with a below-market interest rate, the IRS may consider it a gift rather than a loan. And the gift tax may come into play.
This is usually not a problem for the recipient – the responsibility for reporting lies with the lender or donor. If that’s your role in the transaction and the amount exceeds the gift tax exclusion ($15,000 for 2020, or $11.58 million over a person’s lifetime), you’ll probably just have to fill out an additional form when you file your taxes.
The person who receives the money will not have to report it as income or pay taxes on it, even if the loan is never repaid.
What about interest paid on a personal loan?
If you deduct interest on loan payments each year, including student loans and your mortgage, you may be wondering: Can I also deduct interest on my personal loan?
In most cases, it doesn’t work that way. It is not possible to deduct interest on a personal loan unless you can prove that you used the funds for business expenses. If this is the case, you should consult a tax professional before filing your return, to make sure that you are entitled to tax relief and that you are claiming it correctly.
Today’s top tax software providers will connect you with a tax professional if you need to talk to someone about your loan.
But in general, during tax season, a simple personal loan used for personal expenses will not increase or decrease your tax liability.