Personal loans are often a sound financial decision for many. From fixing and upgrading your home to consolidating other debts, opportunities abound for the taking. But before taking out a personal loan, you should know the tax implications.
1. Personal Loans are Taxable Income
Though you may be tempted to write them off as a business expense, personal loans are taxable income. You may not be taxed on the entire amount in the first year of its use; however, you can only deduct the outstanding balance for tax purposes if it is repaid within a certain period. The due balance will be treated as income for that tax year unless fully repaid within the stipulated period.
2. Personal Loans are Not Deductible Interest Payments
When you take out a loan to purchase an asset, you can deduct the interest payments from your taxable income. However, interest payments cannot be removed when taking a personal loan. Interest payments are considered part of personal income and may be taxed accordingly.
3. Personal Loans are Tax-Free to the extent of Loan Repayment
Personal loans are also non-deductible in the first year, but after that, you can deduct 100 percent of the interest payments and other associated loan cost repayments. The only exclusion from this is when you borrow to pay for a home you purchase or refinance; however, your loan amount will be subject to tax when it is repaid.
4. Personal Loans are deducted from Capital Gains
If you sell or liquidate an asset, such as a real estate property and receive capital gains, you may deduct your loan amounts to purchase that property based on the terms of your loan agreement. You will often see it stated in the contract or handshake that personal loans should not be endorsed as capital gain.
5. Personal Loans are Not Affected by Capital Losses
Capital losses cannot be carried forward for future use. This differs from other losses, like business and investment losses, which can be carried forward indefinitely. When you end up with a capital loss, you can deduct the loss from your income and then reduce your capital gains. If you cannot remove the capital loss, it will be carried forward as a future gain.
6. Personal Loans are Subject to Tax and Penalties when you Fail to Repay
When taking out a personal loan, you must pay annual interest even if you don’t use the loan amount. If you fail to repay the loan or repay it with a lower amount than what was lent, you can be charged a penalty and may be required to pay an additional amount. A large portion of the personal loan amount may also be included as income for that tax year.
8. Personal Loans for Businesses will be treated as Business Loan Interest
If you pay back all or part of a business loan, the amount paid back is considered taxable income – unless it was taxed before it was paid back. This is known as taxable income recapture. Loans to buy investment property will also be taxed as ordinary income. When you take out a personal loan for business use, and the interest is incurred before you pay it back, it can be claimed as a deductible expense. You will also have to assess whether or not it will qualify as an allowable expense and whether or not the terms of repayment are reasonable. Depending on your business, you may have to wait a certain period before claiming the deduction.
9. Personal Loans are Subject to Alternative Minimum Tax
Specific provisions of the Tax Code require you to pay taxes at a higher rate. In some situations, this will result in paying more than the standard tax rate. The Alternative Minimum Tax is set at 25 percent and applies to income from personal loans when taxable; this means that the AMT may apply even if you pay the entire loan back. When your income tax is calculated, it is determined after considering deductions and other factors.
10. Personal Loans for a Relative Are Deductible as GIFT
When you lend money to relatives and friends, the loan terms will be based on standard business principles, but you are still not allowed to deduct the outstanding balance on your personal income tax return. With that said, you can deduct it on your annual gift return or take a partial deduction on Schedule A of your personal income and gift tax returns – if you have already paid the person back in full and cannot deduct it.
11. Personal Loans for Unpaid Debts Are Non-Taxable
When you make a loan that is not paid back, you can deduct the interest charged on your income tax return. However, if the amount you’ve lent is for an unsecured debt like rent or a car lease, it will not be included as taxable income. If a personal loan has been taken out and you understand that the individual won’t be able to repay it, it is considered non-taxable income.
12. Personal Loans for Married Couples Is Deductible as Joint Income
Taking out a personal loan to support one of you as part of a joint financial agreement is considered joint income. You will be taxed at your combined or individual tax rate. This is also the case if you lend money to your spouse for them to use on their business, but it is not considered joint income if the spouse uses it to buy a private asset.
13. Personal Loans are Deductible on a C Corporation
A personal loan used for qualified corporation purposes is deductible from the corporate tax return, but this is subject to various conditions. Corporations must also ensure they don’t deduct more than the fair market value of the property and personal assets used as collateral.
14. Personal Loans Made To Friends and Family Are Tax-Free
When a personal loan is made to a friend or family member, the interest paid back is considered non-taxable income, regardless of whether or not it is distributed to you at any time. The interest earned on the money will also not be included in your taxable income for that year. You may deduct the interest earned when you make your annual gift return or Schedule A of your federal income tax return.
15. Personal Loans can be Challenged as Undue Hardship
Like in any legal proceeding, the lender may challenge the borrower’s loan repayment if they feel they have not been paid back according to the initial agreement. They will have to prove that undue hardship has occurred – meaning that both parties made reasonable efforts, and yet a complete loan repayment was impossible. The court will then decide whether or not legal action is required.
Taking out a personal loan is an excellent way to finance your business; in most cases, it’s a smart move. It gives you some flexibility when it comes to paying your expenses and enables you to pay off other debts. Before you part with your money, make sure that you carefully review the various terms and conditions of the loan agreement.
