Are personal loans tax deductible?
Everyone loves tax deductions because they help you save money. So, when tax season rolls around, a fair share of people want to know if you can write off personal loans.
But, there are circumstances where interest on personal loans is deductible. Let's look at those as well as the potential justification for using personal loans for the purpose of tax deduction.
How is interest on a personal loan tax deductible?
Taking out a loan means repaying the principal amount borrowed plus interest. On average, a personal loan of, say, $11,000 with an interest rate of 11.5% will have a repayment timeframe of two to five years.
Now, imagine you took out a loan with a repayment period of two years. You can multiply the original loan amount by the interest rate to get the true cost.
- ($11,500 x 0.115) x 2 = $2,645 in interest for a total of $14,145
After two years, you would have paid $14,145 for the original loan amount of $11,500, or what works out to be about 19% of the initial principal amount.
Because taking out a loan is expensive, the government offers interest deductions on certain loans to incentivize people to borrow money, spurring economic growth and development.
When is interest on a personal loan tax deductible?
Personal loans are usually not tax deductible because they are considered a type of consumer debt rather than investment, although there are exceptions:
If you take out a personal loan to cover both business and personal expenses, you may be eligible to deduct the interest paid on the business portion of the expenses.
For example, the IRS says, “If you borrow money and use 70% of it for business and the other 30% for a family vacation, you can generally deduct 70% of the interest as a business expense.”
Qualifying expenses for your business include transportation and vehicle costs, office rent and equipment, supplies, machinery, and advertising that are typical and essential in your industry.
The IRS considers your Modified Adjusted Gross Income (MAGI) in determining your eligibility for education deductions. MAGI is your total income minus specific tax deductions and adjustments.
In order to claim a deduction for interest on a personal loan used for tuition, your MAGI should be $85,000 or less (or $175,000 or less for joint filers.)
Currently, the maximum annual deduction is $2,500. Deductible expenses include tuition, fees, room and board, textbooks, supplies and equipment, and transportation.
But you might want to think twice if you’re considering taking out this type of loan to fund tertiary education because most personal loans for tuition prohibit the use of funds for these purposes.
The interest paid on loan money used to invest in stocks, bonds, and mutual funds may be tax deductible. However, this does not apply to tax-advantaged accounts like in IRAs, 401 (k)s, or municipal bonds.
Note that you can only deduct interest on the portion of a personal loan used for a qualified investment. Also, to claim this deduction, you must itemize it on your tax return.
How to deduct interest on personal loans
Remember, the IRS limits the amount of interest you can deduct on personal loans to the amount of interest paid, and the loan cannot exceed the fair market value of what it was used to purchase.
Here are five simple steps to ensure your tax return is correct:
- Gather information: you will need your loan agreement, statement, and receipts to support your claim
- Calculate the interest paid: refer to your loan statements or contact your lender
- Determine the deductible amount: remember, only a portion of the interest is deductible
- Claim the deduction: itemize the deductions on Schedule A of your tax return
- Keep records: It's important to keep all supporting documents for at least three years in case the IRS requests them for verification
Benefits of using specialized loans for education and business
Taking out a student or business loan is a more favorable option when funding expenses related to education or starting a business for the following reasons.
Specialized loans may have lower interest rates and extended repayment terms. For example, the average interest rate for student loans is 5.8% compared to 11% for personal loans.
Moreover, the average loan term for a student or business loan can be as long as 20 to 25 years, whereas a personal loan is between two to seven years.
Student loans may offer deferment options or loan forgiveness programs for certain careers, such as public service professions, while business loans come with tax benefits.
Specialized loans are also tailored to the specific needs of students and business owners. Often, the amount and repayment terms are based on factors such as academic program, income potential, or business plan.
A better credit history
Specialized loans help build a favorable credit history. Because they are customized for individuals pursuing education or business ownership, they indicate responsible borrowing in the eyes of lenders.
When to use personal loans for educational and business expenses
Of course, there are also scenarios where a personal loan may be a better short-term solution:
- To fund a small business: If you are starting a small business and need capital to cover startup costs, especially if you don't have an established credit history or collateral to secure a business loan
- Certain education expenses: If you have fully utilized all available forms of financial aid and are required to cover costs such as books and living expenses
- For flexibility: Unlike some business or education loans, personal loans do not restrict how funds are used, and they are also processed and disbursed within a few business days
Hire a tax practitioner to write off interest on personal loans
While interest on personal loans is deductible in some cases, the process is complex because you have to calculate a percentage of the interest paid. This is where collaborating with an experienced tax practitioner is helpful.
They understand tax laws and regulations and can help you reduce errors and penalties. Most important, they will maximize your personal income tax deductions.