Are personal loans taxable — is a common question among borrowers, which we are going to answer today. Knowing whether a personal loan is taxable or not is very important so you’d know your obligations as a borrower, and avoid any problem in the future.
Business Insider defines a personal loan as the “money that you receive from a bank, credit union, or online lender and pay back with interest over time.” Furthermore, it says that personal loans are instalment loans that are usually unsecured. In addition, they typically come with either fixed or variable interest rates.
Unlike other forms of loans or financing, a personal loan can be used for basically just about anything. That is why it is not surprising why a lot of American people are getting personal loans.
In fact, in data published by the Chamber of Commerce, it says that currently, there are 19.1 million consumers who have used an unsecured personal loan. More so, the total outstanding personal loan debt in the country is $143 billion.
Such a very huge amount, right?
You see, the data we shared only shows that personal loans are indeed popular among Americans – that’s of course apart from credit cards, which is also very accessible to all.
But with all that’s been said, one question remains unanswered – are personal loans taxable?
Allow us to just say that the question is very much valid. With almost everything being taxed, it is just right that as a borrower, you are aware of what you should expect when borrowing money from a financial institution. After all, the last thing you want is surprising charges, right?
As mentioned, today, we are going to focus mainly on knowing and understanding whether or not personal loans are taxable.
To be specific, we are going to particularly answer the following questions:
- Are personal loans taxable upon receipt of the money?
- Are personal loans taxable if it’s forgiven or cancelled?
- Are secured debts taxable?
- Are the interest payments tax-deductible?
- What debt expenses are deductible?
- What are the exemptions to the rule?
Now, before we answer the above-mentioned questions, here’s a quick run-through first about personal loans. These are very important information that you should be well-aware of when planning to get or apply for a personal loan.
WHAT IS A PERSONAL LOAN?
As mentioned earlier, a personal loan refers to the amount of money borrowed from a financial institution, which the borrower needs to pay back with interest over time.
Unlike other forms or types of financial products and services, a person can be used for almost anything. You can use it for buying expensive stuff, for renovating your home, for a personal emergency, or you can even use it for purchasing a car if you want to get away with collaterals, which is very common among car loans.
Speaking of collateral, most, if not all personal loans that are available in the market are unsecured loans, which means you do not need collateral to be able to get approved or to be able to apply for a loan. However, unlike secured loans, unsecured ones have higher interest rates.
If you want to know more about personal loans, here’s a personal loan 101 by MoneyCoach. Check this very helpful and informative video blog by clicking the play button below:
WHAT ARE THE DIFFERENT TYPES OF PERSONAL LOANS?
Before we answer questions related to are personal loans taxable, allow us to share with you first the different types of loans out there. We felt the need to share this with you as later on, you will encounter these terms.
Anyway, there are two types of personal loans. These are secured loans and unsecured loans.
In a separate article about personal loans that we wrote, we defined these two as follows:
A Secured Loan is a type of personal loan that is backed by collateral such as a certificate of deposit or a savings account. In case the borrower is not able to make payments for the loaned amount, the lender is given every right to claim the borrower’s asset as payment for the loan in lieu of cash payments. Since the collateral reduces the lender’s risk, it’s typically easier to qualify secured loans as compared to unsecured loans. Apart from that, lenders also offer more favourable terms.
Meanwhile, an Unsecured Loan refers to a type of personal loan that is not backed by collateral. Most lenders that offer unsecured loans base their qualifications on the borrower’s financial history. While it draws a lot of borrowers because of its scheme, one downside of unsecured loans is that they usually have a higher interest rate.
WHERE TO APPLY FOR A PERSONAL LOAN?
There are three major places where you can apply for a personal loan. You can either borrow money from a bank, through credit unions, or the more popular means these days, through online lenders.
Here’s a quick briefer of each so you get to have an idea about the difference of one to another:
- Banks — Among the three places where you can apply or get a personal loan, banks are probably the most accessible of all as they are almost in every corner (especially if you are living in the central area). It’s probably safe to say that all banks offer personal loans. However, requirements and terms differ from one bank to another. When borrowing money from a bank, you have to do it personally. Meaning, you need to go to their branch and fill out all forms and submit personally all documents required.
Compared to the other two, banks are stricter when it comes to requirements. As with interest rates, they also vary but usually, banks charges higher interest compared to credit unions and other online lenders.
- Credit Unions — Most personal loan borrowers prefer credit unions as they give really good rates as compared to banks and online lenders. Credit unions are member-owned, not-for-profit financial cooperative, which means, you are not just a lender, but a part-owner of the organization as well. This means you are entitled to a lot more benefits.
The only downside of credit unions that we see is the fact that you need to be a member to be able to loan money and enjoy the other benefits they offer.
- Online Lenders — Thanks to the advent of technology and the internet, online lenders came to life. Obviously, this refers to money lenders who make processing more accessible and easier by doing everything online. Yes, no in-person business, just pure online. In fact, some online lenders are very efficient enough that they give approvals just minutes after submission of a loan application.
Online lenders are ideal for people who badly need money as soon as possible. However, you have to be aware that most online lenders charge higher interest rates as compared to credit unions and other banks.
Again, take note that when it comes to requirements, it varies from banks to credit unions to online lenders. So, ideally, it’s best to check them first and compare before coming up with a decision.
Anyway, so now that you already know a few basics about personal loan, it’s time to proceed to the real deal – are personal loans taxable?
ARE PERSONAL LOANS TAXABLE?
To be upfront, unlike other forms of loans, the tax consequences of personal loans are a bit trickier to understand. It’s probably because of the fact that unlike other loan types, personal loans are very flexible.
As we mentioned earlier, personal loans are used for nothing specific. Basically, you can use it for anything that you need money for — it could be as lame us just buying an expensive item, or buying a car or paying for an emergency.
Having said that, we are going to look deeper into different tax aspects of personal loans — particularly if they are taxable and other equally important matters that you need to keep in mind before you seal a deal with any financial institution.
ARE PERSONAL LOANS TAXABLE UPON RECEIPT OF THE MONEY?
There are some people who borrow money through personal loans worry that once they take out a personal loan, they will have to consider it as income, and include it on their tax returns. The thing is, it’s not always the case. In fact, in most personal loans, you do not owe any taxes on the money you borrowed.
Generally speaking, regardless of the type of loan, IRS does not consider loans as income. It, instead, recognizes that the money you got will eventually be repaid over time. Thus, you do not have to report it on your tax return.
ARE PERSONAL LOANS TAXABLE IF IT’S FORGIVEN OR CANCELLED?
By this time, the next question you have in mind would be are personal loans taxable if they are forgiven or cancelled?
To be honest, answering this question can get a little complicated.
For one, if a part of your unsecured personal loan balance is forgiven or cancelled, which means you are no longer expected to repay the remaining balance, the IRS can then consider the remaining balance as income.
So, what happens is, your lender might send you over a Form 1099-C, which basically indicates the amount of the cancelled debt. The same amount is expected to be reported as your regular income on your tax return.
For example, you loaned $10,000. After repaying $4,000, you figured you can no longer finish paying the whole thing. Luckily, your lender has forgiven you or cancelled the remaining $6,000 from the principal amount. That $6,000 will then be expected to reflect as a regular income in your tax return.
It is important to note that you only need to report the amount of money that was forgiven or cancelled and not the entire loaned amount.
ARE SECURED DEBTS TAXABLE?
Now, what about secured debts? Are they taxable, too?
As mentioned earlier, secured loans require collateral. So, what if you are unable to pay off the remaining balance of the money you owe, and then the lender instead claims the collateral as payment for the remaining loan balance? Do you need to report that?
Well, it depends. It depends on the loan contract. You may or may not report a portion of the cancelled debt to the IRS.
To be more specific, there’s what they call as recourse and nonrecourse debt.
Recourse debt, also known as recourse loan, refers to a debt that is backed by collateral. This type of loan allows the lender to collect from the borrower and his or her assets in case of default payments.
Once the lender claims your secured property, the difference between your debt and the fair market value of the item will be considered taxable.
So, based on our example a while ago, if for instance your asset or collateral amounts to $3,000, all you have to do is subtract that amount and then report $3,000 in taxable income.
Nonrecourse debt or nonrecourse loan, meanwhile, refers to a secured loan that is secured by collateral, which usually is an asset or a property, but for which you, the borrower is not personally liable.
In this case, the fact that the lender repossessed the asset or property, it is already considered as sufficient payment. Thus, you no longer have to report the cancelled amount or loan as ordinary income.
You see, if you are not familiar with all these, it really is complicated to understand. That is why we highly recommend that before you file a tax return, you should consider consulting with a tax professional first to help you determine what you owe. This also helps give you peace of mind knowing that your taxes are reported and paid accordingly.
ARE THE INTEREST PAYMENTS TAX-DEDUCTIBLE?
Unlike other types of loans like student loans and business loans that may have tax-deductible interest payments, which can help lessen your income based on the interest you pay, personal loans do not come with the same tax benefit.
Generally speaking, you will not be able to deduct the interest you pay on taxes when it’s a personal loan.
However, there is an exemption. That is if you can prove to the IRS that you used a part of the loan or the entire loaned amount for business purposes.
Again, to be sure, we highly recommend consulting a tax professional first before you seek this type of tax break. This will also help you understand fully your obligations and responsibilities tax-wise.
WHAT DEBT EXPENSES ARE DEDUCTIBLE?
Personal loans are not tax-deductible. However, there are other forms of loans that are tax-deductible.
For instance, interest paid on student loans, business loans, as well as mortgages is usually deducted on your annual taxes, which helps reduce your taxable income for the year.
But, keep in mind also that there are specific criteria that need to be met to be able to qualify for such deductions. For instance, mortgage interest is only deductible if the loaned money was taken out of the fund to be able to purchase a primary residence.
You may be able to claim a tax credit only if you were issued a mortgage credit certificate. This is usually availed through a government program for low-income housing projects.
WHAT ARE THE EXEMPTIONS TO THE RULE?
Personal loans can be used for almost anything including for financing of a business. In this case, when a borrower uses the loaned money for business expenses apart from personal expenditures, the borrower may be able to claim the interest paid on those expenses on his or her taxes.
However, you have to ensure that you are the person who is legally liable for the loan and that you must be able to itemize what particular part of the interest paid is attributed to the legitimate business expenses.
The same goes when you use a personal loan to buy a car or any types of vehicle for business use. If you are using the vehicle entirely for business, then all the interest is deductible. However, if you use it for both personal and business use, then you may deduct loan interest proportionate to the amount of time you use the vehicle for business purposes.
The exemption is also applicable to those who use a personal loan to invest in a partnership, an S corporation (S subchapter), or a limited liability corporation (LLC).
But, to be sure and to be clear when it comes to rules and all, it’s always best to consult a tax expert.
FINAL THOUGHTS ON ARE PERSONAL LOANS TAXABLE
A personal loan is probably the most commonly used form of loan among borrowers. Apart from the fact that you can borrow money for whatever reason or purpose, it’s also very accessible. Some financial institution even offers very competitive rates just so more people loan money from them.
However, it is important that before we borrow money, we know its tax consequences. After all, you do not want to deal with tax concerns, right?
Thus, it is common for borrowers to ask — are personal loans taxable?
While in most cases, the answer to this question is no, there are also instances when you might have to pay taxes particularly on loans that are either forgiven or cancelled. In addition, with personal loans, most of the time, you cannot expect to enjoy tax breaks on the interest you pay.
While borrowing money through a personal loan can be so tempting, it is always best to only borrow money when you need it most. Be wise in handling money to avoid paying off debts all the time, and more so, avoid loan-related taxes.
Are you planning to apply for a loan anytime soon?