Personal loan funds are generally not taxable. Here are some of the few exceptions where a portion of your loan funds may be taxable.
- If your remaining loan balance is forgiven
- If your debt is canceled or discharged
- If you receive a Form 1099-C
Other factors can further influence whether loan proceeds count as taxable income. For example, bankruptcy, insolvency, and loan type can all affect whether it is possible to avoid taxation.
Personal loans are a versatile loan that can help you afford major purchases, consolidate debt, and handle emergencies. Many people wonder if taking out a personal loan makes the loan funds count as taxable income, since the borrower receives a lump sum deposit for flexible use.
While most personal loans don’t count as taxable income, there are important exceptions. Let’s dive into what situations can make a personal loan taxable, and what special cases you should know.
Basic understanding of personal loans
A personal loan is a type of loan individuals can obtain from credit unions, banks, and online lenders. If your loan is approved, the lender will disburse loan funds into your account. You can then use these proceeds for a wide range of purposes, such as debt consolidation, urgent expenses, major purchases, and dream events.
Here are the main characteristics of the standard unsecured personal loan:
- No collateral requirements
- Quick access to funds
- Fixed interest rate
- Few to no restrictions on fund usage
- Interest rate between 6 and 36 percent
Your interest rate and terms are determined based on your creditworthiness and financial stability. The better your credit score, the more favorable a personal loan offer you can receive from lenders.
Are personal loans taxable?
In most cases, personal loans are NOT considered taxable income. Borrowed money that must be repaid doesn’t count as income in the first place. This means that if you obtain a personal loan, it is highly unlikely that you will need to pay tax on the loan amount you receive.
However, there are several exceptions in which your personal loan may be taxable. Let’s go over the essentials that you should know.
Taxable exceptions and other important tax implications
Here are the most common cases in which taking out a loan may result in the proceeds being taxable.
Loan forgiveness has tax implications that can influence whether your loan proceeds are taxable. If your personal loan is forgiven or canceled, you will need to file a 1099-C tax form. This counts as a source of cancellation of debt (COD) income.
The amount of tax you need to pay for your personal loan depends on how much has been forgiven. For example, if you took out a $50,000 loan and $20,000 has been forgiven, you will need to pay taxes on that $20,000.
Business loans are usually not considered taxable income. In addition, business loans come with special interest deduction considerations. If you are seeking a loan for commercial use, consider consulting with a tax professional to learn more about steps to take for filing your taxes.
Most personal loan interest is non-deductible. This is because personal loans are generally counted as nondeductible consumer loans.
Interest on personal loans for business expenses
Borrowers who use personal loan funds for investment purposes might be able to benefit from tax breaks. The interest on personal loan funds that are used for business may be deductible.
To prove that you used at least a portion of the loan for business expenses, you will need to provide thorough documentation and proof, especially if you are self-employed or operate a small business.
If you use a personal loan for investing into the stock market (or other types of investment), you may owe taxes based on how much you earn on the investment.
Note that many online lenders prohibit borrowers from using their personal loan funds for investment purposes. This means you are generally not allowed to invest the borrowed money into the stock market, mutual funds, and other financial assets. Popular loan providers such as SoFi and LightStream are two example lenders with restrictions surrounding investments. These restrictions exist in part because using a loan for investments can be quite risky.
Before taking out a personal loan for investing, assess your personal financial stability. Even if the investment fails, you will still be expected to repay the loan. Defaulting on the loan or not having money to make payments on time can damage your credit score and lead to severe financial repercussions.
Loans vs. income
A loan requires the borrower to repay the debt over time. The interest rate can be variable or fixed, and loan terms can vary greatly between weeks and decades depending on what kind of loan you take out.
Most personal loans have a repayment term between 12 and 60 months. They are also typically fixed-rate, unsecured personal loans with no collateral requirements. If you choose a secured loan, you will need to put up assets as collateral.
Personal loans are given to individuals. Lenders look at two main factors when evaluating an individual’s loan application: creditworthiness and financial stability. They will assess the prospective borrower’s:
When you receive income, it doesn’t come with a repayment obligation. You don’t have to pay the income back, and you can use it freely as you wish.
Common sources of income include:
- Wages and salaries
- Stock options
- Financial assets
- Self-employment income
- Miscellaneous income
There are two types of income: taxable and nontaxable.
Nontaxable income includes:
- Welfare payments
- Cash rebates
- Gifts and bequests
- Child support payments
- Certain healthcare benefits
- Adoption reimbursements
- Qualified scholarship
Whether income is taxable or nontaxable can be complicated. Make sure you review your income types in detail to see whether you’re filing your taxes correctly.
IRS and canceled debt
The Internal Revenue Service (IRS) enforces and administers federal tax laws. The IRS is responsible for numerous processes, including tax audits and tax returns.
How the IRS sees forgiven debt
In the official IRS Topic No. 431, the IRS outlines their perspective on forgiven debt. Canceled debt is generally taxable if the debt has been discharged, canceled, or forgiven for less than the amount owed.
What is a Form 1099-C
The Form 1099-C is the “Cancellation of Debt” form that a lender or creditor must send if they have forgiven or canceled someone’s debt. Form 1099-C is only necessary if a debt of $600 or more has been canceled. Less than that and the form will not be required for compliance.
Potential exclusions: bankruptcy and insolvency
Any debts that are discharged during bankruptcy should not be considered taxable income. However, timing is critical. The debt must be canceled or forgiven while you have ALREADY declared bankruptcy.
To ensure that your canceled debt is not taxable, make sure you have completed your Chapter 7 or Chapter 13 bankruptcy filing before you receive a Form 1099-C.
Insolvency can also help you write off your existing debt without making the forgiven debt count as taxable income. You will need to prove to the IRS that you were insolvent before the cancellation of your debt.
Special kinds of debt
Certain kinds of debt can avoid taxation even if they have been canceled or forgiven. For example, qualified farm indebtedness and real property business indebtedness may not require you to pay taxes on the canceled debt.
Actions to take if your loan is forgiven
If your loan is forgiven or canceled, it might be a good idea to consult a tax professional. The expert can look at your individual situation and give you guidance regarding your tax returns and debt status. Accurate reporting is essential for taxes because mistakes and inaccuracies can lead to problems down the line. A tax professional can help you evaluate potential exclusions, reductions, and other important tax considerations.
Are forgiven student loan amounts counted as taxable income?
It is good to know that if your student loan amounts are forgiven under Public Service Loan Forgiveness (PSLF), those amounts won’t be considered taxable income by the federal government. However, note that this amount may still be counted as income for tax purposes at the state level.
Tax requirements may change over time. While student loan forgiveness is tax-free at the federal level, this may change after 2025. Check the IRS’ guidelines for the latest information on taxation.
Tips for handling personal loans with tax implications
If you have a personal loan or are looking to obtain one, it’s advisable to consider the potential tax implications.
Here are some strategies to implement that can help you improve your personal loan management, especially if there are tax implications.
Keep thorough records and documentation
Having complete records of all your employment information, income, loan accounts, and debt obligations can help you better deal with tax necessities.
Be aware of potential tax implications before using a loan for business and investment
If you use a portion of your personal loan for business purposes, you may be able to benefit from tax breaks.
Review your loan terms and conditions carefully
Your loan terms and conditions don’t just affect your interest rate and fees, but also determine your approved fund usage. This may have tax implications. If your loan is forgiven, make sure you read and understand all the loan forgiveness terms and 1099-C information that will be given to you.
What happens if you don’t pay taxes on canceled debt?
Failing to pay your taxes can result in serious repercussions. Carefully review your tax obligations if you receive any kind of tax form from your loan provider or creditor. Getting tax audited can be problematic, and failing to file your Form 1099-C property with your federal tax return can lead to various penalties.
Unfortunately, having debt forgiven can result in a significant tax expense. Exactly how much you will end up needing to pay can depend on various factors, such as your earnings and deductions.
In some cases, you can legally avoid paying taxes on canceled debt. However, this involves special situations, such as if you have already filed bankruptcy before the debt has been canceled.
Always refer to the IRS’ guidelines and publications for the most up-to-date information on loans and taxation. You can also search for reputable tax professionals and consultants to receive personalized guidance for managing loans and taxes.
Here are some useful links and resources.
- IRS guidelines for canceled debt and taxation
- PSLF student loan forgiveness information
- Best tax relief companies of 2023
- Best personal loan companies
1. Are personal loans taxable?
A regular personal loan is not taxable. However, in exceptional cases, the loan funds will be taxable.
2. When are loans taxable?
If your debt is canceled, forgiven, or otherwise discharged, it can be taxable. If this happens, you will receive a Cancellation of Debt tax form (Form 1099-C).
3. Are all canceled debts taxable?
Not necessarily. In a few cases, you can avoid paying taxes on canceled and forgiven debts. For example, if you have filed for bankruptcy before receiving a Form 1099-C from your lender, you might not need to file taxes on the forgiven amount.
4. Should I contact a tax expert?
It is generally advisable to reach out to a tax professional if you’re worried about the tax implications of taking out a personal loan. A consultation is particularly recommended for those facing loan forgiveness, investments, bankruptcy, insolvency, and other special situations. An expert can help you determine your next best steps and ensure your taxes are filed accurately and completely.
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