Are Personal Loans Taxable?

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When you take out a loan, it's important to know the potential tax consequences. Find out everything you need to know about personal loans and taxes here.Image source: Getty Images.

When you take out a loan, it's important to know the potential tax consequences. Find out everything you need to know about personal loans and taxes here.

Nearly every American has taken a loan at some point during their lifetimes. Whether it's using a mortgage loan to buy a home, taking out a home equity loan to tap into the value of their real estate, or getting an auto loan to buy a vehicle, the right loan can give you the ability to do things you wouldn't otherwise be able to afford. In addition, in some cases, there are tax breaks that make such loans even more valuable.

Personal loans don't get as much attention as most other types of loans do. That's largely because unlike most loans, personal loans aren't for any specific purpose. Instead, you can use a personal loan for pretty much whatever you want, and your lender will let you pay back the loan over its specified term in exchange for the interest you agree to pay over the course of the loan.

The flexibility of personal loans also makes their tax consequences a bit trickier to understand than other loans. Below we'll look at the different tax aspects of personal loans, including whether they're taxable and what other things you'll need to keep in mind about them at tax time.

Is a personal loan taxable when you receive it?

Some people worry that when they take out a personal loan, they'll have to treat it as income and include it on their tax returns. However, that's almost never the case, and with most personal loans, you don't owe any taxes on the amount you borrow.

The only exception to this is with an informal personal loan that you receive, where the person lending you the money doesn't really expect to get repaid. Even in the case of something not intended to be a true loan, there generally won't be any income tax liability, because outright gifts that you receive generally aren't taxable either. Only if the person making the loan is your employer would there potentially be an element of compensation involved, which could make the IRS question whether it's a legitimate personal loan or rather just a way of giving you extra earnings from your job while trying to avoid taxes.

Is a personal loan taxable if it’s forgiven?

A different answer applies if you take out a personal loan and it's later forgiven. The tax laws governing personal loans and other forms of credit include a specific provision covering what's known as cancellation of debt. If you have debt forgiven, then the IRS will treat you as though you had income equal to the amount of the forgiven debt -- and it'll tax you on that forgiven amount.

To understand why, it's useful to consider an example. Say that you got a $10,000 bonus at your job and used it all to pay off a $10,000 debt. In that case, you'd have to pay income tax on your bonus because you earned it as part of your work. However, you'd be out of debt, so you'd still be better off financially even though you decided not to keep any of the cash bonus for yourself.

Now consider the cancellation of debt situation in which your lender simply forgives your $10,000 debt. From your perspective, no money changed hands, so you might think that you wouldn't have to pay any taxes. However, from a financial perspective, you're just as much better off with your debt paid off in this scenario as you were in the last one. To treat both situations equally, the IRS forces you to recognize taxable income in the amount of the forgiven debt.

In practice, this can get even more complicated, because various situations are treated differently. For example, if you have your personal loan cancelled as part of a bankruptcy proceeding, then it doesn't create taxable income, even if it would if your lender simply cancelled the loan itself. Moreover, there've been various tax provisions over the years that have temporarily exempted certain types of loan forgiveness from being taxed. Those provisions don't typically cover personal loans, but if you use the personal loan for certain purposes, then you might have been able to argue that they'd qualify.

Are the interest payments on a personal loan tax-deductible?

Finally, one question that most borrowers have about personal loans is whether they're allowed to deduct the interest they have to pay on their loans. Given that interest rates on personal loans can be relatively high compared to mortgage loans and certain other types of debt, the ability to deduct the interest would be highly valuable in many cases.

Unfortunately, personal loan interest generally isn't deductible against your taxable income. The reason is the same as why the personal loan doesn't get taxed as income: It's a loan for personal financial purposes, and interest on personal obligations usually isn't eligible for a deduction.

However, there are some situations in which you can make an argument that the interest on your personal loan should be deductible. Because you can use the money you borrow through a personal loan for just about anything, it's possible that if the particular use qualifies for a deduction, your loan interest should as well. If you use a personal loan to start a new business or make an investment, you'll want to consult with a tax advisor before taking any final position on your tax return, but it's worth asking the question if you use personal loan proceeds for purposes like these.

Be tax-smart with personal loans

A personal loan can be an easy way to get cash you need quickly, and for the most part, you don't need to worry about major tax consequences. Because personal loan proceeds aren't taxable when you receive them, just about the only common situation in which you'll have to worry about a major taxable event is if your lender's kind enough to forgive your debt for you.

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