You know how much you spent on your personal loan, but do you know what qualifies as interest? In other words, can you deduct the interest you paid on a personal loan? The answer can be complicated. So here’s what you need to know about tax deductions for personal loan interest.
Tax Deductions on Personal Loan Interest
A personal loan interest deduction is a payment for the use of money. Specifically, it’s the cost associated with borrowing money. Interest is not tax-deductible, and it is not a business expense. The IRS does not allow deductions for personal loans to family members or friends either—even if you don’t charge each other interest on these loans. “There are specific instances when you can legitimately deduct your personal loan interest at tax time,” Lantern by SoFi professionals explains.
Understand what qualifies as interest.
Interest refers to the cost of borrowing money. When you get a personal loan, the bank or lender charges you interest on the loan amount. Interest can be charged on loan, credit card balance or line of credit.
The term “interest” does not always refer to an upfront borrowing charge. The lender may require daily payments for each day that you owe them money rather than charging one lump sum at the end of your loan term (as is common in mortgages). This type of payment plan is called accruing interest because it earns more and more over time as time goes on without being paid off by any principal reduction.
It’s also possible for this type of plan to work out so that it’s less expensive than paying off your loan early—but only if there are no prepayment penalties involved!
Figure out which interest expenses you can deduct.
It could be deductible if you’re paying additional interest on a personal loan. However, the tax deduction is limited to the amount of personal loan interest that exceeds investment income from your savings and investments. In other words, if you have $10 in personal loan interest and only $5 in investment income—the extra $5 of an interest payment can be deducted from your taxable income.
Keep your loan interest deduction in check.
You’ll want to be careful when deducting your interest. You can only claim the portion of your payment toward interest, not principal. So, for example, if you pay $100 per month on a $100,000 loan with a 7% interest rate, only $7 is deductible. So if you’re making payments on an interest-only mortgage, it’s important not to deduct any amount above what goes toward paying back interest each month.
Some loans aren’t eligible for this deduction: those in excess of $1 million; those taken out by businesses; reverse mortgages; student loans; or home equity lines of credit (HELOCs).
It’s important to understand what qualifies as personal loan interest and how much of it you can deduct. You don’t want to take on more debt than necessary, but you also want to take advantage of every opportunity for tax savings. By following these guidelines, you can ensure that your interest deductions are always reasonable amounts that will benefit your bottom line now and into the future.