by Dan Caplinger | March 11, 2019
Banks offer many different types of loans to help their customers finance various purchases. If you want to purchase a home, then a mortgage loan can meet your needs, while those looking to do necessary upgrades to their existing homes often find home equity loans to be useful. Vehicle purchasers often turn to auto loans to help them finance their cars and trucks. For those who have needs that don't fall into these narrow categories, personal loans are often the best available choice, as they don't require collateral and give you complete flexibility in what you do with the money you borrow.
One key element of loans for various purposes is what tax implications they'll have. For instance, with money you borrow to purchase a home, mortgage interest is often deductible as an itemized deduction on your tax return, and the tax savings that those deductions can produce can make a huge difference in the after-tax cost of owning a home. However, in many cases, other types of loans, such as auto and personal loans, don't typically lend themselves to tax deductions -- and you'll have to dig deeper to see what, if any, tax implications they'll have.
Below we'll look into personal loans a bit more closely to show you how they can affect your taxes. In general, most personal loans don't have many tax consequences, but a lot depends on what you use the money for.
The first thing to recognize is that when you take out a personal loan from a bank or other financial institution, it won't be treated as taxable income. Sure, you're getting money now, but you also assume the obligation of paying it back at some point. Just as you won't be able to deduct the principal repayment when you pay back the loan, you won't have to pay income taxes on the loan proceeds when you receive them.
The only real exception to this rule is when you get a personal loan from someone who has a relationship with you rather than an impartial third-party financial institution. For instance, if your employer extends a personal loan to you but doesn't really expect to get paid back, then the IRS might choose to treat it as a form of compensation and force you to recognize the "loaned" amount as income. However, such loans are extremely rare, and as long as there's a good-faith expectation that you're going to pay the loan back, it'd be hard for tax authorities to make the argument that you should have to treat the loan as income.
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Once you've taken out the loan, you'll owe interest payments at regular intervals on your personal loan. Those who are familiar with deducting interest on other types of loans -- especially mortgage and home equity loans -- might wonder whether the interest on personal loans is also eligible for deduction.
The answer to this question depends on what the ultimate purpose of the personal loan is. The general rule for the IRS is that if you take out the loan for purely personal purposes, then the interest on the loan isn't tax-deductible. Only if the loan was taken out for a permissible deductible purpose will you be able to deduct the interest you pay on it.
As an example, if you borrow money in order to make an investment, the interest paid can be treated as qualified investment interest that's eligible for a deduction against any investment income that you have. That most often comes up in the brokerage context, when you take out a margin loan against the value of your investment portfolio and use it to purchase additional investment securities. In that case, the interest is almost always deductible because there's an obvious and direct link between the loan and your investment activity.
With a personal loan, you're allowed to use the proceeds for any purpose you see fit. So you'll need to demonstrate that you used the loan to make an investment in order to deduct the interest accordingly. However, if you can do so, then you'll have a reasonable argument that the interest should be deductible.
The same argument is available for other types of deductible expenses. Using a personal loan to start a business makes the interest a business deduction. It's important to document your uses accordingly, and a tax advisor can give you details. But it's worth pursuing whether a personal loan's interest might be deductible despite the nominal personal nature of the loan.
The tax-free nature of a personal loan hinges on the expectation that you'll have to pay it back. If the loan is later forgiven, then you'll typically have to include the forgiven amount as income. That's because of provisions known as cancellation of debt, which forces taxpayers in most situations to recognize forgiven debt as income.
However, the rules vary from situation to situation, depending on what caused the financial institution to forgive your personal loan. If you file a bankruptcy proceeding and obtain a court order that cancels your personal loan debt, then the specific laws governing bankruptcy keep you from having to recognize taxable income. By contrast, a simple decision from your bank not to force you to repay the loan can result in cancellation of debt income. It's always worth looking to see if special exemptions apply, but you'll typically have to pay the IRS something if your loan is forgiven.
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Personal loans are designed to be flexible and easy to deal with, as they'll have fewer restrictions and specific requirements than specialized loans like mortgages or home equity loans. However, the tax benefits aren't always as large with personal loans. By being aware of the general rules governing personal loans and tax consequences, you'll be more likely to avoid nasty surprises and manage your tax liability appropriately.
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