As a general rule, you cannot deduct the interest that you pay on a personal or family loan. The IRS considers these standard lending products, with the same rules whether you borrow from a family member or the bank. However, there are some exceptions. For certain types of loans, like student loans or business-related loans, the IRS may allow you to deduct your interest payments. If you use a personal loan for that kind of qualifying expense, you may be able to deduct your interest. You can work with a financial advisor who can advise you about getting a loan, repaying your loans and how you can build wealth long-term.
What Is a Personal Loan?
A personal loan is a structured loan that you take out and repay as an individual. You can take personal loans from any lending institution or other individuals, meaning that a personal loan can equally come from a bank or a family member.
Most personal loans are unsecured. Sometimes you may be asked to put some asset up as collateral to the loan, but this is uncommon. This is because personal loans are effectively an undefined form of lending. They aren’t a specific category of loans such as a mortgage, business, auto or educational loan. In most cases, a personal loan is backed by nothing more than the borrower’s creditworthiness and guarantee of repayment.
Most personal loans are relatively short-term, with payment periods of around five years or less. They also tend to be smaller than other forms of lending. This is in part because personal loans tend to be unsecured, so there’s no major asset that allows a lender to justify larger loans.
Personal Loans and Taxes
As a general rule, personal loans do not affect either your taxable income or your tax deductions. The amount you receive in a personal loan does not count towards your taxable income. This only changes if the lender forgives your loan, at which point the forgiven amount does qualify as income for that year. Nor, so long as the borrower structures it properly, is the loan considered a gift.
This is because you’re expected to repay this loan with market-rate interest, meaning that you have purchased access to this money. The loan is no more income than any other product or service that you pay for. With a few exceptions, you also cannot deduct your interest or principal payments on a personal loan for the same reason. When you make payments on a loan, you’re literally paying for a service.
The lender gave you access to cash and interest is what you pay for that. Under ordinary circumstances, this is no more tax deductible than any other payments you make for a product or service. However, there are certain types of loans that the IRS does allow tax deductions on.
The Three Allowed Deductions
If you take out a personal loan, you may be able to claim a tax deduction for your interest payments under three circumstances:
- Higher education expenses
- Business expenses
- Taxable investment expenses
1. Higher Education Expenses
If you take out a formally structured student loan, you can typically deduct the interest that you pay on those loans up to $2,500 per year.
Most people who borrow money to pay for higher education do so through a specifically defined student loan because these products come with different protections than ordinary loans. Elements like income-based repayment and hardship deferrals make student loans better for most borrowers than ordinary large-scale lending.
However, you can also use a personal loan to pay for qualifying educational expenses. Typically, qualifying educational expenses means educational expenses that you could have paid for with a government-backed student loan, such as tuition or student fees.
If you use all of the money from a personal loan to pay for qualifying educational expenses then you may be able to deduct the interest from that loan in the same way that you would a government-backed student loan. The $2,500 cap will apply and you must use the entire loan for qualifying educational expenses, otherwise, it will not count.
2. Qualifying Business Expenses
As with higher education, typically someone who borrows to fund a business will do so through a formal business loan. However, depending on the nature of the business, you can pay for these expenses with a personal loan as well.
Qualifying business expenses generally relate to anything necessary for running or maintaining the business. For example, new equipment or office supplies may count. Paying for the services of an accountant or lawyer might also apply. If you pay for these expenses with a personal loan, you might be able to deduct the interest on your loan payments as a qualifying business expense.
Unlike with higher education expenses, you don’t have to use the entire loan. If you pay for qualifying business expenses with a portion of a personal loan then you can deduct the interest proportional to the amount you spent on the business.
Finally, whether you can deduct business expenses depends significantly on your relationship with the business. Qualifying business expenses apply to freelancers, the self-employed and small business owners. The more of an owner you are the more likely it is that this exception will apply.
For example, a small business owner who uses a personal loan to pay for new computers is far more likely to qualify for this exception than a big-box retail clerk who does the same thing. Overall, the deductible status of an expense will depend heavily on the business, your relationship to it and the specific nature of each expense.
3. Taxable Investment Assets
Under some circumstances, you can deduct the interest on a personal loan if you use it to buy investment assets. Readers should note that it is very rare for this to be a good idea. Leveraged investing, meaning investments that you make with borrowed money, can be extremely dangerous and ordinary investors should typically avoid it.
This exception does not apply to all financial products. Qualifying assets tend to be mainstream securities such as stocks and bonds. Nor can you deduct your interest payments if you hold those assets in a tax-advantaged account like an IRA or a 401(k) or if you buy tax-advantaged assets like a municipal bond.
Finally, if you have qualifying investments, you can only take this deduction against qualifying investment income for the year. This must be realized income, so for example you must sell assets for a profit or collect dividend or interest payments. If you do not have investment income, you cannot take a tax deduction for investment expenses.
The Bottom Line
A personal loan is a loan that you take out as an individual. It’s typically backed by nothing more than your own creditworthiness and most personal loans neither count as taxable income nor do they provide a tax deduction. However, you can deduct the interest that you pay on a personal loan if you use it for one of a handful of qualifying expenses.
Tips for Borrowing
- Whenever you borrow money, regardless of the reason, you should make sure you are careful and get good advice. A financial advisor can help you plan out how a loan fits into your overall financial plan and what the repayment terms might do to your budget so that you don’t miss a beat with retirement savings. If you don’t have a financial advisor, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Personal loans can be a difficult area to navigate. Most smart borrowing decisions are covered by specific loan products, like a mortgage or a student loan. Regardless of what you’re borrowing for you probably should make sure that your debt-to-income ratio is never excessive.
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