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Personal loans can be a big help when you need money in a relatively short period of time. A personal loan can help you with emergencies, cover home repair and renovation costs, help you consolidate high-interest debt and much more.
But when tax time comes around, you may find a personal loan doesn’t come with as many advantages as other types of loans you may have taken out. After all, you can deduct the interest on your mortgage, your home equity loans, student loans and business expenses, why shouldn’t you be able to do the same for your personal loans?
Unfortunately, the answer is usually no. You can’t deduct the interest on your personal loans. But when it comes to taxes, for every rule there are some exceptions.
To learn more about whether your personal loans are tax deductible, read on.
Understanding How Personal Loans Affect Your Tax Return
First, it’s helpful to understand what it means to deduct any kind of interest on your tax return.
When you take out a loan, you borrow a certain amount called the principal; you pay interest on top of paying back the principal. The interest is what the lender charges you to borrow money.
When you’re allowed to deduct the interest on your taxes, you essentially delete that amount from your annual income. So if you earned $50,000 in taxable income and were able to deduct $2,000 in interest, you’d only have to pay taxes on $48,000.
On the plus side, the Internal Revenue Service (IRS) won’t count your loan as income, but they also won’t let you deduct the interest on a personal loan. However, there are three categories of exceptions to the rule: business expenses, qualified higher education expenses and taxable investment.
Let’s say you own a small business or work as a freelancer or consultant. To get your business started, you may need to borrow money to help cover startup costs like renting office space, buying materials or hiring someone to create a website for you.
If you take out a personal loan to cover all or part of these expenses, you can write the interest off as a business expense. However, you can only write off the interest related to your business. So if you buy a car but use it for both work and personal use, you can only deduct the percentage of the time you use it for work.
However, while personal loans can be convenient – and charge less interest than a credit card – you’re likely to pay more in interest than you would with a small business loan or small business line of credit.
Qualified higher education expenses
Higher education is expensive. If you were to take out a personal loan to cover qualified expenses like tuition and academic fees or if you use the money to refinance an existing student loan, you may be able to deduct the interest on your taxes.
However, there are some restrictions to consider:
- The personal loan must be for you, a spouse or dependent while they’re enrolled at least half-time in a recognized school with a degree, certificate or credential program.
- If your tax filing status is married filing separately, you can’t claim the deduction.
- The deduction will be based on your modified adjusted gross income (MAGI) for the year. If you earn too much, the interest may not be deductible.
However, personal loans usually come with higher interest rates and a shorter repayment period than most federal and private student loans. We’ll go into more detail shortly, but if you can get one of these student loans, it’s probably a better option than a personal loan.
There are certain types of investments usually involving stocks, bonds and mutual funds where any income from the investment is taxed. If you were to take out a personal loan to invest in one of these investments you could deduct the taxes from your personal loan.
However, these types of investments tend to be higher-risk, especially compared to retirement accounts like a 401(k), which only requires you to pay taxes when you withdraw funds. So If the return on your investments doesn’t cover the costs of paying back your personal loan, you’ll have to pay it back out of pocket.
Also, you’re limited to the net investment income you earned at your ordinary income tax rate and you’ll need to itemize your deductions to take advantage of the deduction. Unless your itemized deductions exceed the standard deduction of $13,850 for a single filer or $27,700 for a married couple filing jointly, you’re not likely to benefit from the tax deduction.
Instead, these types of investments are usually only recommended for investors who have already maxed out the amount they can contribute to their non-taxable 401(k), IRA and other retirement accounts.
Types of Loans With Tax-Deductible Interest
Since you can’t usually deduct the interest from a personal loan, you may want to consider a different type of loan that does allow for a tax deduction. Depending on your needs, you may also find these loans offer lower interest rates, more manageable repayment terms and other benefits as well.
When you apply for education programs, you’ll likely want to fill out a Free Application for Federal Student Aid (FAFSA) form and talk to your school’s financial aid office about applying for student loans. Doing this makes you eligible for both federal and some private student loans.
Why use a student loan over a personal loan?
- Interest is deductible: The interest as well as the origination fees is tax deductible, as long as your income is below a certain level.
- Lower interest rates: Federal student loans currently have interest rates ranging from 4.99% – 7.54% while most personal loans start around 10% and can go as high as 15% or more.
- Longer repayment periods: Personal loans tend to have repayment periods ranging from 3 – 10 years. Student loans allow for repayment periods of 10 – 30 years. The longer repayment period means you’ll have a smaller monthly payment to deal with, though you may pay more in interest over the life of the loan.
- Other tax benefits: Student loans are considered an above-the-line deduction, meaning you may be able to claim it even if you don’t itemize your deductions. Using student loans may also help you qualify for other tax deductions or education tax credits.
If you’re looking to buy a home or an investment property, you’ll probably want to take out a mortgage rather than use a personal loan.
- Higher borrowing limits: For most borrowers, personal loans max out around $20,000 and while some personal loans will let you borrow as much as $100,000, it’s nowhere near the borrowing power of a mortgage loan, which has a federal loan limit of $726,200.
- Lower interest rates: While the 30-year fixed mortgage rate was around 6%, the rate for personal loans was around 10% or higher. When you’re borrowing hundreds of thousands of dollars, those percentage points make a big difference.
- Mortgage interest is deductible: In fact, you used to be able to deduct up to $1 million in mortgage debt on your tax return. That changed with the Tax Cuts and Jobs Act of 2017 (TCJA) and the deduction is now capped at $750,000. But it’s still a pretty good deduction for most of us.
If you’re a homeowner looking for a way to borrow money, a second mortgage in the form of a home equity loan (HEL) or home equity line of credit (HELOC) can also be a great way to borrow money, assuming you have enough equity in your home.
Like mortgages, a HEL or HELOC uses your home as collateral, so the interest rate will be comparable to the lower rates you’d expect from a mortgage loan.
Previously the mortgage interest was deductible regardless of how you used the money. The TCJA changed that, so now you can only claim a tax deduction if you use the money to buy, build or repair a home.
So if you want to use a HELOC to finance a deck or make a down payment on an investment property, deduct away. Just keep in mind, the limit applies to your total mortgage debt, not just per property.
Also, if you want to use a second mortgage to pay off your credit card debt, you’ll pay less interest than you would with a personal loan, but you won’t be able to deduct the interest.
Small business loans
If you need money to start a small business, your bank or credit union might be able to offer you a small business loan. Or if they can’t, you may be able to get a microloan from the U.S. Small Business Administration (SBA). Microloans allow you to borrow up to $50,000, and the interest rates on microloans range from 8% – 13%. Even better, the interest is tax deductible.
FAQ: Frequently Asked Questions
Still not sure about how personal loans may affect your taxes? Here are the answers to a few common questions.
Are personal loans considered taxable income?
The short answer is no. Since you need to repay the money you borrow, personal loans aren’t considered income.
Do I have to report a personal loan on my taxes?
Also no. That’s actually good news. Since a personal loan isn’t considered income, you don’t have to report it to the IRS when you file your tax return.
What happens if your personal loan is canceled or forgiven?
While it doesn’t happen often, you may find that your loan has been canceled or forgiven. When that happens, the balance of your loan is considered taxable income unless the loan was forgiven due to bankruptcy or insolvency. Whatever the situation, you’ll need to report the loan forgiveness using a 1099-C tax form.
Refund From Uncle Sam
So if you have a personal loan, the good news is that the IRS doesn’t see it as income, which means you don’t have to include it on your tax return. The less-good news: You can’t deduct the interest except in a few situations.
But knowing that, you can make an informed decision about the best type of loan for you when it’s time to borrow and when it’s time to file your taxes.
Internal Revenue Service. “Qualified Education Expenses.” Retrieved July 2022 from https://www.irs.gov/credits-deductions/individuals/qualified-ed-expenses
Internal Revenue Service. “IRS provides tax inflation adjustments for tax year 2023.” Retrieved January 2023 from https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2022
Federal Student Aid. “Understand how interest is calculated and what fees are associated with your federal student loan.” Retrieved July 2022 from https://studentaid.gov/understand-aid/types/loans/interest-rates
National Credit Union Administration. “Credit Union and Bank Rates 2022 Q3.” Retrieved January 2023 from https://www.ncua.gov/analysis/cuso-economic-data/credit-union-bank-rates/credit-union-and-bank-rates-2022-q3
Federal Housing FInance Agency. “FHFA Announces Conforming Loan Limits for 2023.” Retrieved January 2023 from https://www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Announces-Conforming-Loan-Limits-for-2023.aspx
Internal Revenue Service. “Interest on Home Equity Loans Often Still Deductible Under New Law.” Retrieved July 2022 from https://www.irs.gov/newsroom/interest-on-home-equity-loans-often-still-deductible-under-new-law
U.S. Small Business Administration. “Microloans.” Retrieved July 2022 from https://www.sba.gov/funding-programs/loans/microloans