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Some loans come with tax breaks, like the ability to deduct the interest you paid or a certain portion of expenses. If you’ve taken out a personal loan or are considering one, it’s natural to wonder what your options are when tax season rolls around.
In this article, we’ll explain when you can deduct the interest you pay on your personal loans and when you cannot. We’ll also cover how personal loans affect your income for tax purposes and answer some frequently asked questions.
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Is Personal Loan Interest Tax Deductible?
In most cases, you cannot deduct the interest you pay on personal loans from your tax return.
One of the reasons is that personal loans are so flexible. From home renovations to weddings or vacations, you can use personal loans for almost anything.
Think of it this way: the government isn’t going to give people tax breaks because they upgraded their deck or financed a trip to Paris.
To deduct interest from a loan on your taxes, it must be used for a qualifying purpose as determined by the Internal Revenue Service (IRS). Most personal loan uses do not meet that standard. However, some of them do, and that’s where the exceptions come in. We’ll discuss those in more detail later.
Do personal loans affect your income for tax purposes?
Personal loans do not count as income in the eyes of the IRS. That means you don’t have to add the amount you borrowed towards your earnings for the year.
The reason is that taking on a personal loan means taking on debt that must be repaid. This is fundamentally different from earning money. So even if you borrow a large personal loan (for example, one worth $40,000 or more) you don’t need to worry about it changing your income tax bracket.
Personal Loan Tax Deduction Exceptions
There are three categories where using a personal loan might allow you to deduct the interest from your taxes.
1. Business expenses
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.
2. 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 a 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 if your spouse is the one with the expenses.
- 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.
- Funds must be used to pay for the academic period that starts during the tax year or the first three months of the next tax year.
However, personal loans usually come with higher interest rates and a shorter repayment period than most federal and private student loans. If you can get one of these student loans, it’s probably a better option than a personal loan.
3. Taxable investments
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 riskier, especially compared to retirement accounts like a 401(k), which only require 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
Remember, if you need a tax break to afford to repay any loan, it probably isn’t the best option. That said, here are some other loan types that can allow you to deduct interest from your taxes:
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 for debt consolidation tax-deductible?
No. Because debt consolidation doesn’t fall under the qualifying purposes discussed in the exemptions, you cannot deduct the interest you pay. However, debt consolidation can still be a great way to save on interest and potentially lower your monthly payment while simplifying your finances.
Are personal loans for home improvements tax deductible?
No. If the personal loan isn’t being used for one of the exemption categories laid out above, the interest is not tax deductible.
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.
Final Thoughts On Personal Loan Tax Deductions
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.
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The Short Version
- Generally, interest paid on personal loans is not tax deductible. But there are exceptions based on their use
- The three exceptions are using a personal loan for business expenses, qualified higher education expenses and taxable investments
- Personal loans don’t count towards your income for tax purposes because you must pay the money back
Internal Revenue Service. “Qualified Education Expenses.” Retrieved November 2023 from https://www.irs.gov/credits-deductions/individuals/qualified-ed-expenses
nternal Revenue Service. “IRS provides tax inflation adjustments for tax year 2023.” Retrieved November 2023 from https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2023