Depending on what you’re borrowing money for, a personal loan can amount to a fairly large sum of money. It’s important to understand the tax implications of receiving this money and of paying it back. In some cases personal loans don’t have any tax implications at all, but in others they can alter your tax picture significantly.

Are Personal Loans Treated as Taxable Income?

In most cases, a personal loan is not considered taxable income. As usual, however, the tax law contains a few exceptions. Because you have to pay the money back, the IRS generally doesn’t view a personal loan as income. But it could be if repayment isn’t required.

Let’s say, for example, your boss gives you a personal loan but tells you that you don’t have to repay it if you use it as a down payment on a house. If you do, in fact, use the money as a down payment on your home as directed, the money is taxable since it becomes yours to keep. If you use the money for something other than the specified purpose, however, it wouldn’t be income since you would have to pay it back. If, for instance, you used the money to buy a motorcycle instead, the personal loan money isn’t taxable because you now have to pay it back. Your boss probably won’t loan you money ever again, but your taxes won’t be impacted.

You could also face tax implications if you make money from your loan. Again, an example will clarify. Pretend you’ve taken out a personal loan to buy some new household appliances. After you get the loan, a friend who works in the appliance store tells you they’re having a big sale in three months. You toss your loan money in a savings account and wait for the sale. Any interest you earn on that money while you wait is taxable. The same is true if you take out the loan to purchase stock or another investment vehicle. The loan itself isn’t taxable, but the money you make on the investments you purchase with it is.

Be aware that there could also be tax implications for your lender. Pretend you want to buy a car but you’re having trouble getting a loan for some reason. To help you out, your brother loans you the money. The current interest rate for a personal loan is about 5 percent, but your brother is only charging you 2 percent. The IRS may view this significantly reduced interest rate as a gift, which would require your brother to report the git on his income taxes. If it exceeds the annual allowed gift value, your brother may have to pay gift tax on a portion of the money he loaned you.

Are Interest Payments Tax-Deductible?

In a word: Maybe. Unlike mortgage interest and interest on student loans, the interest paid on a personal loan is generally not deductible. That can change, however, depending on what you use the loan for. Did you take out a personal loan to start a business? If so, your loan interest might count as a deductible business expense.

The same is true if you use the loan to purchase investments. In this case, you may be able to use your interest payments as a deduction against your investment income. This typically only occurs when you take out a margin loan with your investment broker, but it’s a helpful tip to be aware of.

Because you can use a personal loan for whatever you want, there are some situations in which you can get away with deducting the interest you pay. It’s a good idea to talk to a CPA to make sure you’re not missing a chance to deduct your interest payments.

Canceled Personal Loans Create Taxable Income

This is very important, so we’ll say it again: A canceled personal loan creates taxable income. The reason that the money you receive from a personal loan isn’t taxed is that it’s not really yours. At some point, you have to give it back. But that changes if your debt is canceled.

Pretend you unexpectedly lose your job and then your car breaks down. Your friend loans you some money so you can get your car fixed. Before you can pay your friend back, her elderly father gets sick. Since you’re out of work, you offer to take care of him until he gets back on his feet. In return, your friend tells you not to worry about paying her back.

While it was very sweet of your friend to cancel your debt, she just unintentionally handed you a tax liability. The money she loaned you wasn’t taxable when you were going to repay her. But now that the money is yours to keep, you owe Uncle Sam income tax on it. Fortunately, however, you only pay tax on the money you keep.

If your friend loaned you $1,500, for example, and you had already paid back $500 before her father fell ill, you would only owe tax on the $1,000 your friend forgave. You wouldn’t owe on the $500 you already repaid.

The same thing happens when you settle with a credit card company. You may be able to convince your cardholder to accept $2,000 as payment in full if you owe them $3,000. The $1,000 of forgiven debt becomes taxable, however. This gets a lot of people into trouble when they go through debt consolidation and negotiation programs. The relief they feel at getting rid of some of their debt turns to panic when they realize they now owe the IRS money they may not have.

Be aware, however, that how you cancel your debt matters. If the court grants you bankruptcy protection, it may also shelter you from paying tax on any canceled debt. Depending on how they’re structured and instituted, some student loan forgiveness programs can also cancel your debt without creating a tax liability.

Getting Help From A Pro

As you can see, even something as simple as a loan between friends can become quite complicated when the IRS gets involved. Fortunately, the professional accountants at Picnic Tax are always at the ready. We can help you find ways to make the interest on your loan tax-deductible and help determine whether or not you owe any tax on the loan money you receive. We’re here every day, ready to help minimize your tax liability legally and safely. Sign up today and let’s see what we can do about making your personal loan do as much work for you as it possibly can.