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Paying interest is an inevitable cost of borrowing money, but there could be some benefits. Many people wonder if the interest you paid on a personal loan is tax deductible.
In this article, we’ll explore the tax implications of your personal loan interest payments to see if you can benefit come tax season.
Are Personal Loans Tax Deductible?
Like any credit, you must repay your personal loan with interest, and the longer the loan term, the more interest you’ll pay over the loan's lifetime. So, it may leave you wondering if you can claim a tax deduction for your personal loan.
The short answer is no. Generally, your loan repayments, including any interest paid on your personal loan, are not tax deductible. There are some exceptions, but in most cases, you will not be able to claim a deduction. Many lenders restrict how you can use personal loan proceeds for nondeductible purposes.
This means that unless you used the proceeds of the loan for one of the exception categories when you filed your return, you’d be unable to include your personal loan.
When Can You Get Tax Deductible Interest on Personal Loans?
Three purposes for loan proceeds will allow you to deduct your loan interest on your tax return.
1. Business Expenses
Most business owners know that creating or running a business involves considerable costs, so you may need a loan to cover them.
You don’t need to operate a large business to take advantage of this deduction, as you could qualify even if you run a side gig as a consultant or freelancer. Depending on what you use your loan for, the interest accrued may be tax deductible.
The interest accrued on loan used to purchase supplies for products you create and sell or buying furniture for rental properties may be considered a deductible business expense.
This means that you can subtract the expense from the income produced by your business, which will reduce your annual tax liability. If your business income is less than your expenses, you could even carry a loss for the year that could be used to offset other sources of income.
Suppose you’re using a personal loan for both personal and business expenses. In that case, you will only be able to deduct the interest attached to the loan portion used for your business expenses.
2. Educational Expenses
Typically people take out a private or federal student loan to cover the costs of higher education, and there is a good reason for this. Dedicated student loans typically have special repayment plans that will better align with students' needs than other finance types.
Additionally, most federal student loans will not require a credit check and you may qualify for hardship or forgiveness programs.
However, if you do use a personal loan to refinance your student loans or pay for a qualified educational expense such as college fees, tuition or required activity expenses, it may be considered as a qualified student loan. This means that your interest payments could qualify for student loan interest deduction and you could deduct all the interest that you paid for the full year.
Student loan interest deductions can be particularly valuable as it is an above the line deduction making it more of an adjustment rather than simply being a deduction. However, there are limitations and requirements.
For example, you cannot claim a deduction if you have a married filing tax status but you’re filing separately. Additionally, the amount of the deduction may be reduced depending on the modified adjusted gross annual income.
3. Taxable Investments
If you use your loan funds to purchase taxable investments, you may be able to deduct your interest. However, the deduction will not be allowed if you’re purchasing tax-advantaged investments, such as a tax-exempt bond.
If you are using the loan for different types of investments, you can take a deduction for the interest corresponding to the amount that you used for qualified investments. You will need to itemize your deductions, so you can take the investment interest deduction, which makes it difficult for most people to benefit.
Additionally, you will only be able to deduct interest against the investment income for the year. If you don’t have sufficient investment income, you will be able to roll over your qualifying interest payments to the following year for offsetting future investment income. If you take a personal loan to buy a car, for example, you can't deduct your interest.
Which Loans offer Tax Deductible Interest?
There are several types of loans that offer tax deductible interest. These include:
- Student Loans
If you take out student loans to cover qualified higher education costs, you can deduct up to $2,500 for interest payments each year. Qualified expenses include tuition, textbooks, lodging and other necessary expenses.
You can take a deduction even if you don’t itemize, but the deduction phases out according to your modified adjusted gross income.
- Mortgages
Although the 2017 Tax Cuts and Jobs Act did create new rules for mortgage interest payment deductions, it didn’t eliminate deductions altogether. You can still deduct mortgage interest when the funds have been used to buy, improve or build a home.
If you purchased mortgage interest points, you may also deduct those payments. In either scenario, you need to itemize the deductions to benefit. There are also limits on how much interest you are able to deduct.
- Second Mortgages
The interest on second mortgages may also be deductible, but the mortgage value limit will apply to a combined balance of both your first and second mortgages.
Additionally, the loan proceeds must be used to substantially improve your home by extending its lifespan or increasing its value.
- Business Loans
If you take out a business loan, you may be able to deduct the interest that you pay. To qualify you must be liable for the debt, intend to repay it and have a true creditor-debtor relationship.
For example, if you borrow money from a family member to start a business and you decide to offer some interest when you repay the gift, it will not count. However, if you take out a loan to purchase equipment or supplies for your business, you could take a deduction.
Are Personal Loans Considered Income?
You don’t usually need to pay income taxes on the proceeds of a personal loan, as you need to repay the funds. However, there are some exceptions to this.
For example, if you have a federal student loan under an income driven repayment plan, any remaining loan balance may be canceled after 20 plus years. At this stage, the lender may send you a 1099-C which shows how much of the debt was canceled and you’ll need to include it in your tax return.
Similarly, if you settle a debt for less than the outstanding balance or you negotiate debt reduction, you will need to be prepared for the tax implications. So, while you may save money, you may get hit when you file your return. However, there are some exclusions and exceptions when you won’t need to include canceled or forgiven debt in your taxable income.
For example, there are certain federal student loan forgiveness programs where the forgiven amount will not be taxable. Generally, when more of your debts are forgiven or canceled and if you have more liabilities than assets, all or part of the forgiven amount may be excluded. Additionally, discharged debts when you file bankruptcy are not taxable income.
The Bottom Line
Although getting a tax deduction on the interest you’ve paid on your personal loan may be appealing, it applies only in specific circumstances. So, it is a far better idea to try to minimize the amount of interest that you pay in the first place.
Be sure to shop around for a loan deal that not only meets your requirements but minimizes the total payable cost, so you can apply for a loan, save money on your interest payments and don’t need to worry about saving a few dollars with a tax deduction.
FAQs
No. Generally, it will only be classified as income if all or part of the debt is forgiven. However, there are some exceptions to this. So, before you agree on a settlement, be sure to check the tax implications.
Since it is not considered income, you don’t need to report your personal loan on your taxes. However, if part of your loan is canceled, you will need to report that amount as income.
You may be able to take a deduction in the specific situations and scenarios we’ve discussed in this article.
Some lenders do allow you to use a personal loan for any purpose including settling bills. However, it is not a good idea.
You are likely to have to take the loan out for a specific period and you may find that you need to cover a loan repayment and the cost of your next income tax bill, which could lead to greater financial difficulty.
