Banks offer many types of loans to help their clients finance various purchases, including:
- Mortgage for home
- Loans secured by real estate for repair or debt consolidation
- Car loans to help finance cars and trucks
- Personal loans for financial needs that do not fall under a narrower category. Most of them do not require collateral and you can use the money however you want.
Loans have their pros and cons, and when we talk about money it is always important to consider the tax implications. For example, mortgage interest is often deducted as an itemized deduction from your tax return. Savings in taxes can significantly affect the total cost of owning a home.
Unfortunately, other types of loans usually do not have tax benefits. In fact, they can sometimes have negative tax consequences.
Below we take a closer look at individual loans to show you how they can affect your taxes.
Borrowed money is tax-free – usually
First of all, it should be recognized that when you take out a personal loan from a bank or other financial institution, it will not be treated as taxable income. Of course, you are getting the money now, but you also commit to returning it at some point. Just as you will not be able to deduct the principal when you repay the loan, you will not have to pay income tax on the income from the loan when you receive it.
The exception to this rule is when you are getting a personal loan from someone associated with you and not from an impartial third party financial institution. For example, if your employer grants you an excusable personal loan and does not expect to be paid back, then the IRS may consider that money as a form of compensation. In this case, you would have to recognize the “loan” amount as income. However, such loans are extremely rare, and as long as there is a good faith expectation that you are going to repay the loan, it will be difficult for the tax authorities to argue that you should treat the loan as income.
Another exception is interest income. If you borrow money and leave it for a while in your high yielding savings account, the interest you earn is reportable and tax deductible.
Interest on personal loans is generally not tax deductible – with a few exceptions.
By taking out a loan, you will pay interest regularly. Those familiar with the interest deduction on other types of loans, especially mortgages and mortgage loans, may wonder if interest on personal loans can also be deductible.
The answer to this question depends on what you are spending your money on.
A general rule of the IRS is that if you take out a loan solely for personal use, the interest on the loan is not tax deductible.
However, if the loan was taken out with a valid deductible purpose, you will be able to deduct the interest paid on it.
For example, if you borrow money for investment, the interest paid can be considered qualified investment interest that is deductible from your investment income. It is most often found in brokerage contextwhen you take out a margin loan for the amount of your investment portfolio and use it to buy additional investment securities. In this case, interest is almost always deducted because there is an obvious and direct link between the loan and your investing activity.
Having received a personal loan, you can use the proceeds for any purpose that you see fit. Thus, you need to demonstrate that you have used the loan for investment in order to deduct interest accordingly. However, if you can do this, you have a reasonable argument that interest should be deducted.
The same argument applies to other types of deductible expenses. Using a personal loan to start a business results in an interest deduction.
Since there are many possible cases where your interest payments could become a tax deduction, it is important to document your use of the funds.
Loan forgiveness usually creates taxable income
The tax-free nature of a personal loan depends on the expectation that you will have to pay it back. If the loan is later forgiven, you will usually have to include the amount received as income. This is because of provisions known as debt forgiveness, which force taxpayers to recognize the forgiven debt as income in most situations.
However, the rules vary from situation to situation, depending on what caused the lender to forgive your personal loan. If you submit bankruptcy and get a court order that will nullify your personal loan debt, and then specific bankruptcy laws prevent you from having to recognize the forgiven debt as taxable income.
On the contrary, your lender’s decision not to force you to repay the loan may result in taxable cancellation of the debt income. This could happen if you enter amortization contract, and your lender forgives, in whole or in part, the personal loan. Indeed, the likely tax liability makes debt repayment much more costly than you might think just by looking at the online advertisements of professional debt settlement companies.
It’s always worth seeing if special benefits apply, but usually you’ll have to pay something to the IRS if your loan is forgiven.
Know the account with personal loans and taxes
Personal loans are designed for flexibility and they are easy to deal with as they will have fewer restrictions and special requirements than specialized loans such as mortgages or home equity loans. However, tax breaks are not always that great with personal loans. Knowing the general rules governing personal loans and tax implications is more likely to be able to avoid unpleasant surprises and manage your tax liabilities properly.