Will You Ever Have to Pay Tax on a Personal Loan?

First, what exactly is a personal loan?

Personal loans are a great option when you need an influx of cash to cover a big expense, like an unexpected medical bill, a wedding or a home repair project.

The loans are usually unsecured debts, meaning you don't have to put up any asset as collateral.

Personal loans are versatile — you can use them for pretty much anything. They can be lifesavers when emergency expenses pop up, plus they're useful for consolidating debt. You can sweep up your costly credit card balances into a personal loan at lower interest to pay off the debt more quickly and affordably.

When you take out a personal loan, there are no surprises. You’ll typically borrow a fixed amount at a fixed interest rate, and you’ll have a set deadline for repaying the money.

Interest rates vary by lender and will depend on factors including your credit score.

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Do personal loan proceeds count as income, for taxes?

A loan is money you borrow and are expected to pay back — so no, it’s not considered income. Because the IRS is primarily interested in the funds you earn and keep, loans generally aren’t taxable.

That remains the case as long as you stay current on your loan and pay off your debt on time and in full.

But if you fall behind on your payments or stop making them, the tax question can have a different answer.

When a personal loan can trigger taxes

If your income or situation ever changes and you can no longer afford your loan payments, you could wind up defaulting on the debt — and some or all of it may eventually be canceled, either through bankruptcy or if you work with a credit management agency.

When cancellation occurs, your lender will issue you a 1099-c form, which you’ll have to include with your tax return to report how much debt was cleared away.

The IRS is interested because when you don't pay back loan money, you’re no longer borrowing it but instead have received it as income in the eyes of the tax agency.

Let’s say you borrowed $20,000 and managed to repay half before defaulting on the loan. If you never intend to pay back the other $10,000, the IRS will expect you to report it as income on your tax return — and pay taxes on it.

The case of personal loans that truly are personal

There’s one other occasion when a personal loan might bring tax implications, and that's when the loan really is personal — made between friends or family members.

If you offer someone a "loan" with either no interest or a below-market interest rate, the IRS may see that as a gift rather than a loan. And, gift taxes can come into play.

They're generally not an issue for the recipient — the responsibility to report falls to the lender or gifter. If that's your role in the transaction and if the amount is more than the gift tax exclusion ($15,000 for 2020, or $11.58 million over a person’s lifetime), you'll likely just have to file an extra form when you submit your tax return.

The person receiving the money won’t have to report it as income or pay taxes on it — even if the loan is never paid back.

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What about the interest paid on a personal loan?

If you deduct the interest on loan payments including student loans and your mortgage each year, you may wonder: Can I also claim my personal loan interest?

In most cases, it just doesn’t work that way. There's no write-off for a personal loan, unless you can prove you used the funds for business expenses. If that’s the case, you’ll want to consult with a tax professional before filing — to make sure you’re entitled to a tax break and that you’re claiming it correctly.

Today's best tax software providers will line you up with a tax pro if you need to talk with someone about your loan.

But generally during tax season, a straightforward personal loan used for personal expenses won't increase or decrease your tax liability.