Does a Personal Loan Affect Your Taxes?

A personal loan provides a lump sum of money, often unsecured, which borrowers repay over a set period with fixed monthly payments. Understanding how these loans interact with federal taxes is important for borrowers. Receiving the principal amount of a personal loan itself does not create a taxable event.

Receiving Personal Loan Funds

The money received from a personal loan is not considered taxable income by the IRS. This is because a loan represents a debt obligation that you must repay, rather than earnings or profit. The principal amount of the loan does not increase the borrower’s net worth.

Regardless of the lender, the tax treatment of the principal remains consistent. The funds establish a liability for the borrower. You do not need to report this amount on your federal income tax return.

Interest Paid on Personal Loans

The interest paid on a personal loan is not tax-deductible for tax purposes. This differs from other loan types where interest might be deductible, such as home mortgage interest or student loans for higher education. Business loan interest is also deductible.

However, personal loan interest can be deductible depending on how the funds are used. If the funds are used for business expenses, a sole proprietor can deduct the interest on Schedule C. This applies if the loan finances operations, equipment, or other business costs.

Another exception is for qualified investment expenses. Interest paid on a loan used to purchase taxable investments, like stocks or bonds, can be deductible as investment interest expense. This deduction is limited to your net investment income and is reported on Schedule A, with calculations involving Form 4952. While a personal loan is distinct from a direct student loan, using personal loan funds for qualified higher education expenses does not make the interest eligible for the student loan interest deduction, as that deduction applies to qualified education loans.

Loan Forgiveness and Default

When a personal loan is not fully repaid or is forgiven by the lender, it can lead to taxable income known as “cancellation of debt” (COD) income. The IRS generally considers any debt that is forgiven or discharged without repayment as income to the borrower. Lenders typically issue Form 1099-C, Cancellation of Debt, to the borrower and the IRS if the amount of cancelled debt is $600 or more.

Several exceptions exist where cancelled debt may not be considered taxable income. One common exception is insolvency, where the taxpayer’s liabilities exceed their assets immediately before the debt is cancelled. In such cases, the amount of debt cancellation that exceeds the amount of insolvency is typically the only portion that becomes taxable. For example, if liabilities are $10,000 greater than assets, and a $12,000 debt is cancelled, only $2,000 would be taxable.

Debt discharged in a Title 11 bankruptcy case is generally excluded from gross income. This means that if a personal loan is legally discharged through a bankruptcy proceeding, the forgiven amount is typically not taxable income to the individual. There is also an exclusion for qualified principal residence indebtedness, which applies specifically to debt cancelled on a home mortgage, not a typical personal loan.