There are many different types of loans banks and financial institutions offer. Business loans, mortgages, home equity loans, auto loans. All of these loans have sole purposes, such as financing a startup business, buying a home, remodeling your existing home, and buying a car. But what about all those expenses that don’t fit into these narrow categories? Banks also issue personal loans. Personal loans don’t require collateral and give you full freedom in what you decide to use the money for.

However, before you begin taking out personal loans in a hurry, there are a few things you need to know about how personal loans can affect your tax refund.

What are personal loans?

A personal loan is a loan from a financial institution such as a bank, credit union, or online lender. Some common reasons you may need a personal loan, such as for wedding expenses, paying off credit cards, or for emergency moving. They don’t require collateral, which is why their APR is typically higher, ranging between 6 percent to 36 percent. For example, auto loans are typically cheaper, but your car is used as collateral, so if you default the bank or creditor will repossess your car. 

Can personal loans be considered taxable income?

Personal loans are typically not considered taxable income. The reason being is that loans consist of money that is lent, with the purpose of being paid back over time. However, a personal loan can be considered taxable income under one condition: if the loan is forgiven. 

Cancellation of debt income is when the bank, credit union, or lender decides that you no longer need to pay back the loan’s principal or interest. In this case, the lender will send you Form 1099-C, which is used to document forgiven debts over $600. On this form, you will document the amount of money that was forgiven, which will then be taxed. This will normally happen after repossession, foreclosure, abandonment of property, and other similar cases. When this happens, you can either pay the IRS online or mail in a check for the amount due.

Are there ways to avoid paying taxes on personal loans?

In some cases, yes. If you can no longer make regular monthly payments towards debts, you can file for Chapter 7 or Chapter 13 bankruptcy and have your debts discharged in a Title 11 bankruptcy hearing. In these cases, you won’t have to repay your debts. 

Another way to avoid paying taxes on personal loans is if the loan forgiveness is in the form of a gift. In this case, if the amount of debt forgiven is less than your liabilities minus your assets, you don’t have to pay taxes on the forgiven amount.

Is interest on personal loans tax deductible?

There’s no yes or no answer to this question, as it depends on specific circumstances. Usually, interest on personal loans is not tax deductible because the money is used for personal reasons. However, if the loan is taken out for a permissible deductible purpose, you can have the interest on your personal loan deducted.

For example, if you decide to use your personal loan to make investments in things such as stocks or property held for investments, you can deduct the interest on your investments.

What loans are tax deductible?

No matter what, taking out a loan means you’re going to be in debt. This means you don’t want to take out loans with high interest rates that pull you further into debt. Unlike personal loans and credit cards, that are usually not tax-deductible, home mortgages, home equity loans, and business loans are tax deductible. 

Student Loans: According to Forbes, the student debt as of 2019 is a whopping $1.56 trillion. If you’re part of this number, you can deduct up to $2,500 for student loan interest, or the amount of interest you actually paid. Student loans are often used to pay for courses, housing, book rentals, meal plans, and other necessary expenses.

Mortgages and Home Equity Loans: If you are buying a house or remodeling the one you currently live in, you can deduct interest on these loans. For home mortgages, you can deduct interest on the first $750,000 (or $375,000 if married filing separately) of indebtedness. 

Business Loans: There are a lot of intricacies when it comes to deducting interest on business loans. You can find most information on the IRS website here, but for the most part, you can deduct interest on business loans on Form 8990. However, if your business loan is used for business and personal purposes, you can only deduct the percentage used for business purposes only.

The Bottom Line

Personal loans are a great way to get money quickly to pay for immediate expenses you may not have money for at the moment. However, knowing how personal loans can affect your tax refund will ensure you don’t face high interest rates and lose out on deductions.