Will a Personal Loan Affect Your Taxes?

Banks offer many types of loans to help their customers finance various purchases, including:

• Mortgages for homes
• Home equity loans for renovations or debt consolidation
• Auto loans to help finance cars and trucks
• Personal loans for financing needs that don't fit into a narrower category. Most don't require collateral, and you can usually use the money any way you want.

Loans have their upsides and downsides, and when we talk about money, it's always important to consider tax implications. For example, mortgage interest is often deductible as an itemized deduction on your tax return. The tax savings can make a huge difference in the overall cost of owning a home.

Unfortunately, other types of loans don't typically have tax benefits. In fact, they can sometimes have negative tax consequences.

Below we'll look into personal loans a bit more closely to show you how they can affect your taxes.

Borrowed money is not taxable income -- usually

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.

An 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 forgivable personal loan to you and doesn't expect to get paid back, then the IRS might choose to treat that money as a form of compensation. In that case, you would have 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.

Another exception is interest income. If you borrow money and park it for a while in your high-yield savings account, the interest you earn is reportable and taxable.

Interest on personal loans is usually not tax-deductible -- with some exceptions

Once you've taken out a loan, you'll owe interest payments at regular intervals. 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 you use the money for.

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.

If the loan was taken out for a permissible deductible purpose, however, you will be able to deduct the interest you pay on it.

As an example, if you borrow money to make an investment, the interest paid can be treated as qualified investment interest that's eligible for a deduction against your investment income. 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 applies to other types of deductible expenses. Using a personal loan to start a business makes the interest a business deduction.

Because there are many possible instances in which your interest payments can become a tax deduction, it's important to document your uses of the funds.

Loan forgiveness usually creates taxable income

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 force taxpayers in most situations to recognize forgiven debt as income.

However, the rules vary from situation to situation, depending on what caused the creditor to forgive your personal loan. If you file a bankruptcy proceeding and get a court order that cancels your personal loan debt, then the specific laws governing bankruptcy shield you from having to recognize the forgiven debt as taxable income.

By contrast, a decision from your creditor not to force you to repay the loan can result in taxable cancellation of debt income. This could happen if you enter a debt settlement agreement and your creditor forgives all or part of a personal loan. Indeed, the likely tax liability makes settled debt much more costly than you'd think just looking at online ads for professional debt settlement companies.

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.

Know the score with personal loans and taxes

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.