You can use a personal loan for many useful purposes, but borrowing money can be expensive. To keep costs down, you might be wondering: is personal loan interest tax deductible? The answer depends on how you spend the funds.
Here’s what you need to know about deducting interest on personal loans from your taxes — and what happens to your taxes when you don’t repay the full amount you borrowed.
When can you deduct loan interest from your taxable income?
“The tax code allows you certain deductions to reduce your tax liability,” says Jeremy Babener, tax attorney and founder of Structured Consulting in Portland, Oregon.“The IRS is specific about what is and isn’t deductible. In some circumstances, the interest you pay on loans is part of that.”
In most cases, personal loans do not have tax deductible interest. That’s because you can’t deduct personal expenses from your income taxes, says Babener. So if you’re using the personal loan for vacations, debt consolidation, or living expenses, for example, you can forget about the deduction.
There are, however, instances where you can deduct interest on personal loans. If you used the money for any of the following purposes, a tax deduction may be possible. Keep in mind that personal lenders may prohibit borrowers from using funds for these purposes, and there may be better financing options.
Company. If you used the funds for business expenses, you can usually deduct the interest. “You just have to specify that the loan was for this purpose and not for your personal expenses,” says Babener. Sole proprietors can take advantage of this. “Maybe you’re a painter, walk pets, that sort of thing. You can take out a loan, based on your personal credit, to buy what you need for your business.”
Education. You may be able to deduct the interest on a personal loan when you use the money to eligible education expenses, such as tuition fees. But many personal lenders don’t allow borrowers to use the funds to cover post-secondary education, and student loans are better suited for that purpose.
Investments. You may also be able to deduct interest on a personal loan if the money purchased taxable investments such as stocks, bonds, and mutual funds. You will use the IRS Form 4952 to calculate the amount of investment interest you can deduct.
How do tax deductions work?
A tax deduction is a simple subtraction. Each deduction allows you to reduce your taxable income so you will be taxed on a lower figure. Interest deductions are more relevant to consumers claiming itemized deductions on their taxes.
The higher the interest rate and the longer the term, the more overall interest you will pay on a personal loan. The prospect of a personal loan interest tax deduction is attractive when the goal is to save money. But be sure to stick to the letter of the tax law when pursuing deductions.
“You don’t want to get a letter from the IRS because you wanted a $2,000 tax deduction that you weren’t entitled to,” says Paul Miller, CPA at Miller & Co. in New York. “Tax returns have a three-year retention period, but if there is fraud, there is no statute of limitations. There are many legal deductions. Cheating is not the only one to choose .”
Miller advises a conservative approach and checking with a CPA to make sure you’re doing everything right.
Can you be taxed on personal loan funds?
As you consider cutting costs, be aware that there is a situation where you will usually have to pay taxes on your loan proceeds. If the lender forgives or cancels all or part of the debt, the IRS may consider the income of the portion canceled.
Therefore, you may feel relief when you no longer have to make the payments, but you should be prepared for a higher tax bill.
The IRS expects you to report the canceled debt on your tax return for the year the cancellation occurred. You will most likely receive the IRS Form 1099-C from the lender, indicating when the debt was canceled and how much you no longer owe. So if you took out a $10,000 loan and the lender returned half of it, $5,000 can be considered taxable income.
How to save money on your personal loan?
Ultimately, you’ll want to borrow only the amount you need, get the lowest interest rate possible, and arrange to pay off the loan on time or sooner. This way you can minimize the amount of interest you pay. If you want to prepay your loan, check to see if your lender charges a prepayment penalty.
And if you’re able to deduct the interest because it really does qualify, do so. “You want to get as many deductions as possible so that you can effectively take advantage of tax laws to legally reduce your income tax,” says Gregg Munn Jr., Certified Financial Planner and Certified Public Accountant at Sax Wealth Advisors, headquartered in Sax Wealth Advisors. in New Jersey.