At some point, there’s a good chance you’ll face debt. In fact, during the third quarter of 2020, household debt jumped by $87 billion, according to the Federal Reserve Bank of New York’s Center for Microeconomic Data.
Some of that debt comes in the form of personal loans. When that money from a personal loan hits your bank account, it can feel like a financial shot in the arm. But what are the tax consequences? Let’s take a look at personal loans and the IRS implications that come with them.
What Are Personal Loans?
A personal loan is a loan you can use for things like debt consolidation, home improvements, a wedding ring, or medical expenses. The loan can be unsecured, requiring just your promise to repay, or it can be a secured loan, requiring you provide collateral that the lender can seize if you don’t make payments.
Total unsecured personal loan balances were up 5.3% year-on-year to $156 billion in the second quarter of 2020, according to data gathered by credit reporting agency TransUnion.
Overall, personal loans make up a small percentage of U.S. consumer debt, so some people might not familiar with how they work—and how the IRS views them.
Are Personal Loans Considered Taxable Income?
No matter the type of loan, it’s important to note that the IRS generally doesn’t consider loans as income. Loans aren’t wages, income, or gifts. In most cases, your net worth doesn’t increase as a result of borrowing the money. Because of that, you’re not going to be taxed on the amount of money you receive from the lender. The story changes, though, if you end up with a portion of your balance canceled or forgiven.
What Happens If the Lender Cancels or Forgives Your Loan?
In most cases, the IRS can then consider as income any part of your personal loan that your lender forgives or cancels. After all, you’ve benefited from the extra amount in your bank account, since you didn’t end up repaying the money.
Your lender might send a Form 1099-C, which indicates the amount of the canceled debt that you’re expected to report as regular income on your tax return.
Let’s say you borrow $7,000. After repaying $3,000 in principal, you run into trouble and realize you can’t finish paying it off. The lender forgives the remaining $4,000 in principal. At tax time, you’re expected to report that $4,000 as regular income.
Exceptions for Secured Debt
One exception might be if you have a secured loan and the lender claims the property as part of its payment for the debt. Depending on the loan contract, you may or may not have to report a portion of the canceled debt to the IRS, whose rules for secured debt are:
- Recourse debt: After the lender claims your secured property, the difference between what you owe and the fair market value of the item is considered taxable. Using the example above, if you had secured the loan with an item that has a fair market value of $2,000, you can subtract that from the amount you’re taxed on ($4,000), and you would report $2,000 in taxable income.
- Nonrecourse debt: If the secured loan contract is for nonrecourse debt, meaning you’re not personally liable for it, the fact that the lender repossessed the property is considered sufficient payment, and you don’t have to report the canceled amount as ordinary income.
Before filling out your tax return, you might consider consulting with a tax professional who can help you determine what you owe.
Are Interest Payments Tax-Deductible?
Some types of loans, such as student loans, mortgages, and business loans, can have tax-deductible interest payments if you qualify. You can reduce your income based on the interest you pay on these loans.
However, personal loans don’t come with the same tax benefit. If you get a personal loan, you generally won’t be able to deduct the interest you pay on taxes. The main exception, however, is if you can prove to the IRS that you used part or all of the personal loan for a business purpose. Consult with a tax professional before seeking this type of tax break.
The Bottom Line
In most cases, personal loans are not taxable. However, there are times when you might have to pay taxes on amounts that are forgiven. Additionally, with a personal loan, you can’t expect to receive tax breaks on the interest you pay in most instances.
A personal loan might help you make a large purchase, support you in an emergency, or smooth your cash flow. But as with all types of debt, it’s important to use the money borrowed wisely and to find alternatives before moving forward.