Posted by Karen Munoz, EA

Is Income Tax Compulsory on Personal Loans?

Is Income Tax Compulsory on Personal Loans?

As long as you repay such a loan fully, there is no need for income taxes on a personal loan. However, the forgiveness of any part of the loan or paying the loan for a lesser amount warrants taxes. When this happens, the part you are not repaying could reflect on your income tax.

Are Personal Loans Classified as Taxable Income?

Personal loans cannot be taxed as the funds you got is not income. This is different from wages and investment earnings, which you earn, and is yours. 

Since they are not classified as income, reporting personal loans on your return is not necessary. No matter who the lender is – bank, friend, financial institution, etc., loaned you the funds. 

Receiving a personal loan from a friend or a family member might have other tax implications even though such funds are not classified as taxable income. For instance, if it is an interest-free loan, or it is not up to the market interest rate, Uncle Sam will likely consider it as a gift, not a loan.

For gifts above the gift tax exclusion in a year - $15,000 in 2021, the giver might need to file a different IRS form 709. With this, however, one needs not report the receiving of such a gift. Also, there is no gift tax except what you gave is above the lifetime gift tax exemption - $11.58 million. 

Forgiven Personal Loan and Taxable Income 

A borrower might need to pay income tax on some part of your personal loan that was forgiven, canceled, or discharged. 

For instance, you might have an outstanding debt of $3000, and your lender decides that you can settle such debt for $1,400; your canceled debt is $1,600. Such canceled debt is income even if there are interests and fees as part of the canceled debt. You will also get IRS Form 1099C from the lender with which you can prepare and file your return. 

This situation is common with many types of debt. For example, in the federal student loan repayment plans, any outstanding student loan will be waived after 20 to 25 years of making payment, and the forgiven amount is considered taxable income. 

There are, however, exceptions as there are cases when forgiven debts might not lead to taxable income. For debts discharged during bankruptcy, for instance, or someone insolvent at the time of debt forgiveness, such people will not have the forgiven debt classified as taxable income.

Personal Loans: Are they tax deductible?

There is no provision to deduct interest paid on personal loans except such funds directed for specific things and satisfy the eligibility requirement. 

  1. Using part of the entire funds for a business expense. With this, one might deduct the interest payment amount that corresponds to the business income. However, one needs to ensure that the lender allows the loan for business purposes, and you need a record of how you spend the money. 

  2. Taking out a personal loan and using the entire funds to pay educational expenses for you, your spouse, or a dependent is another exception. 

Make sure to check and know if your lender offers personal loans directed at educational expenses and compare such with personal loan offers to real student loans. Many people prefer student loans as they offer reduced interest and qualify for some forgiveness and repayment programs. 

Investment interest also comes with itemized deductions, provided you borrow money to buy tax-exempt investments. So, for an instant, getting a loan to buy stocks, deducting such loan interest is possible even though you can only deduct up to the investment income amount for the year. 

Always Prepare for taxes all Year-Round. 

Even though everyone files a single federal tax return every year, planning for tax occurs throughout the year. One important thing to do is note how your actions might increase taxable income alongside your tax bill or how to get deductions that will bring down your taxable income. 

Personal loans do not have a huge effect on tax planning the same way repaying it will not affect your taxes. However, be mindful of exceptions if any of your debt is forgiven. 



Karen Munoz, EA
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