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You generally don't have to pay income taxes on a personal loan if you repay the loan in full. You might have to if your lender forgives part of the loan or you settle the remainder of your debt for less than you owe. If that happens, the portion you don't have to repay may be included in your taxable income for the year.
Are Personal Loans Treated as Taxable Income?
Personal loans generally aren't taxable because the money you receive isn't income. Unlike wages or investment earnings, which you earn and keep, you need to repay the money you borrow.
Because they're not a source of income, you don't need to report the personal loans you take out on your income tax return. This is true whether a bank, credit union, peer-to-peer lender or another financial institution lent you the money.
If you receive a personal loan from a friend or family member, there may be other tax implications, but the money still won't be taxable income for you. For example, if the loan has no interest or a below-market interest rate, as determined by the current "applicable federal rate," the IRS may consider it a gift rather than a loan.
When a gift is for more than the gift tax exclusion for the year—$15,000 in 2020—the person who gives you the money may have to file an extra form (IRS Form 709). But, even then, you don't need to report receiving the gift. And, the gift giver won't pay any gift taxes unless they've given away more than the lifetime gift tax exemption—which was $11.58 million as of 2020.
Is a Forgiven Personal Loan Considered Taxable Income?
As a borrower, you may need to pay income tax on a portion of a personal loan that's canceled, forgiven or discharged.
For example, if you have a $2,500 outstanding balance on a personal loan and the creditor agrees to settle the account for $1,500, then you'll have $1,000 in canceled debt. The canceled debt is considered income, even if part of the canceled debt is made up of fees and interests. The lender will also send you and the IRS a Form 1099-C you can use to help prepare and file your tax return.
You could wind up with a similar situation with other types of debt as well. With some federal student loan repayment plans, your remaining student loan debt will be forgiven after you make payments for 20 to 25 years, with the forgiven amount considered taxable income.
However, there are also exceptions. A forgiven personal loan doesn't lead to taxable income if, for example, your debt is discharged during bankruptcy. Or, if you're insolvent (you owe more money than your current assets) when your debt is forgiven, then part or all of the forgiven debt could be excluded from your gross income. Some student loan forgiveness programs also lead to debt forgiveness without tax consequences.
Are Personal Loans Tax Deductible?
You can't deduct the interest you pay on your personal loan unless you use the money for a few specific reasons and meet the corresponding eligibility requirements.
One is when you use some or all of the money for a business expense. You may then be able to deduct the corresponding amount of interest payments from your business income. But make sure the lender allows you to take out a loan for business use (some do, others don't), and keep records of how you spend the money.
Another exception could be if you take out a personal loan and use all the money to pay for qualified educational expenses for yourself, a spouse or a dependent. Or, if you refinance a student loan with a personal loan. In these cases, you might qualify to deduct up to $2,500 in interest payments annually.
But again, check with the lender to see if it offers personal loans for educational expenses, and compare personal loan offers to actual student loans. Most people take out student loans because they offer lower interest rates and are eligible for special forgiveness and repayment programs.
There's also an itemized deduction for investment interest if you borrow money to purchase investments that aren't tax exempt. For example, if you take out a loan to buy stocks, you may be able to deduct the loan's interest. You can only deduct up to the amount of investment income you had for the year, but you can roll over additional amounts to offset future years' investment income.
Prepare for Tax Time Throughout the Year
While you may only file one annual tax return, tax planning is a year-round process. Part of this involves knowing how your actions can increase your taxable income and corresponding tax bill, or lead to deductions that can lower your taxable income and payments. Personal loans generally don't play a large role in tax planning, as taking out and repaying a loan generally won't impact your taxes. Still, keep exceptions in mind, especially if one of your debts is forgiven or discharged.