When it comes to taxes, not all loans are created equal. While most loans are not considered income and are usually not taxable, there are certain circumstances where a loan may be considered income and be subject to taxation. In this article, we'll explore the ins and outs of personal loans and taxes, so you can understand how they affect your financial situation. Generally speaking, personal loans are not taxable because the money you receive is not income.
Unlike wages or investment gains, which you earn and keep, you need to pay back the money you borrow. To be classified as taxable income, money must be earned from sources such as jobs or investments. Therefore, personal loans are not considered income and do not need to be reported in your taxes. However, if a loan is canceled or forgiven, it may be counted as income to be taxed.
This happens most often in the context of brokerage, when you apply for a margin loan against the value of your investment portfolio and use it to purchase additional investment securities. It could also happen if you enter into a debt settlement agreement and your creditor forgives all or part of a personal loan. While your personal loan won't be taxed as income, you probably won't be able to deduct interest on the loan as you might do with a mortgage or a home equity loan. Just as you won't be able to deduct the repayment of principal when you repay the loan, you won't have to pay income taxes on the loan income when you receive it.
If you lend a significant amount of money to your children (for example, enough to buy a house), it is important to charge interest. When money from a personal loan reaches your bank account, it can look like a financial injection in your arm. But if you have to cover a significant expense or are looking to consolidate a debt, you don't need to worry about repaying a personal loan to complicate your taxable income during tax season. It's always worth seeing if special exemptions apply, but you'll usually have to pay something to the IRS if your loan is forgiven.
If the loan has no interest or has a lower interest rate than the market rate, as determined by the applicable current federal rate, the IRS may consider it a gift rather than a loan. If you file bankruptcy proceedings and get a court order that cancels your personal loan debt, specific laws governing bankruptcy protect you from having to recognize the forgiven debt as taxable income. Understanding how personal loans affect your taxes will make you feel safer when tax season comes. Most people apply for student loans because they offer lower interest rates and are eligible for special forgiveness and repayment programs.
If you are interested in applying for a personal loan but are not sure what you can afford, a personal loan calculator may be helpful in determining the correct monthly payment amount, term length, and interest rate to suit your needs.