You can use a personal loan for a variety of useful purposes, but borrowing money can be expensive. To cut down on costs, you may wonder: Is personal loan interest tax deductible? The answer depends on how you spend the funds.
Here’s what you need to know about deducting personal loan interest on your taxes — and what happens to your taxes when you don’t pay back the entire amount you borrowed.
[Read: Best Personal Loans.]
When Can You Deduct Loan Interest From Your Taxable Income?
The interest you pay on mortgages, student loans and business credit products is tax deductible, with certain limits.
“The tax code permits you certain deductions to lower your income tax obligation,” says Jeremy Babener, tax lawyer and founder at Structured Consulting in Portland, Oregon.”The IRS is specific about what is and isn’t deductible. Under certain circumstances, the interest you pay on loans is one of them.”
In most cases, personal loans do not have tax-deductible interest. This is because you can’t deduct personal expenses on your income taxes, Babener says. So if you use the personal loan for vacations, debt consolidation or living expenses, for example, you can forget the deduction.
There are some cases when you can deduct interest on personal loans, however. If you used the money for one of the following purposes, a tax deduction may be possible. Keep in mind that personal loan lenders can bar borrowers from using funds for these purposes, and there may be better funding options.
Business. If you used the funds for business costs, you can typically deduct the interest. “You just have to make it clear that the loan was for that purpose and not for your personal expenses,” Babener says. Sole proprietors can take advantage of this. “Maybe you’re a painter, walk pets, that kind of thing. You can take 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 for qualified educational expenses, such as college tuition. But many personal loan lenders do not permit borrowers to use funds to cover postsecondary education, and student loans are better suited for this purpose.
Investments. You may also be able to deduct personal loan interest if the money bought taxable investments such as stocks, bonds and mutual funds. You will use 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 smaller figure. Interest deductions are most relevant to consumers who claim itemized deductions on their taxes.
The higher the interest rate and the longer the term, the more you will pay in overall interest on a personal loan. The prospect of a tax deduction for personal loan interest is attractive when saving money is the goal. 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 didn’t actually qualify for,” says Paul Miller, a CPA at Miller & Co. in New York. “Tax returns have a shelf life of three years, but if there’s fraud, there’s no statute of limitation. There are many legal deductions. Cheating isn’t the one to choose.”
Miller advises a conservative approach and to check with a CPA to make sure you are doing everything right.
Can You Be Taxed on Personal Loan Funds?
As you’re thinking about lowering costs, be aware that there is a situation when you will typically have to pay taxes on proceeds from your loan. If the lender forgives or cancels all or a portion of the debt, the IRS may consider the canceled portion income.
Consequently, you may experience relief when you don’t have to make the payments any longer, but you should prepare for a higher tax bill.
The IRS expects you to report the canceled debt on your tax return for the year the cancellation took place. You will most likely receive 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 forgave half of it, $5,000 may be considered taxable income.
[Read: Best Small Business Loans.]
How Can You Save Money on Your Personal Loan?
In the end, you will want to borrow only the sum you need, get the lowest interest rate possible and arrange to repay the loan on time or faster. This way, you can minimize the amount of interest you pay. If you want to pay off your loan early, check to see whether your lender charges a prepayment penalty.
And if you are able to deduct the interest because it truly qualifies, do it. “You want to obtain as many deductions as possible so you can effectively take advantage of the tax laws to legally reduce your income tax liability,” says Gregg Munn Jr., a certified financial planner and certified public accountant at Sax Wealth Advisors, headquartered in New Jersey.
More from U.S. News