Peer-to-Peer Lending and Taxes

Peer-to-Peer lending is an excellent way both for investors to get returns and for borrowers to access debt markets. For both parties, though, it has tax implications that can make it different from other investments.

Understanding Peer-to-Peer Lending

Anyone who has lent a friend 20 dollars because they forgot their wallet has given a peer-to-peer loan. Peer-to-peer lending is simply a way that people with money can lend it to people who need money without going through the traditional process of depositing the money in the bank, earning interest from the bank, then having the bank lend the deposit money out at a higher rate of interest. Today’s peer-to-peer lending systems frequently involve middlemen who aggregate investors and connect them to borrowers. Although the middleman earns profit for the role that they take, their spread is significantly less than the differential that banks charge between deposit rates and loan rates.

Lending through Peer-to-Peer Channels

For investors with money to lend, peer-to-peer offers excellent returns. Typically, they would register with an entity that advertises for borrowers. When a borrower arises that they would like to lend their money to, the entity facilitates the process, delivering the money to the borrower and the monthly payment stream to the lender.

Borrowing from a Peer-to-Peer Lender

Borrowers approach a peer-to-peer lender just as they would any other lender. Many lenders will require borrowers to provide a credit score to prove their creditworthiness. Assuming that the borrower meets the lender’s standards, they will execute a promissory note and, potentially, a security document to collateralize the loan. Once they have signed off, the lender will give them the money and they will commence making monthly payments.

Taxation as a Peer-to-Peer Borrower

For a peer-to-peer borrower, a loan is just like any other loan for tax purposes. If they are using the loan to repay personal debt, it would be treated like any other personal loan and would not be deductible. On the other hand, the interest paid on a loan for business start-up costs could be written off by the business. Interest on peer-to-peer loans structured as mortgages or second mortgages would also be deductible if they met the same standards as a bank-originated mortgage, although the lender will need to file the appropriate 1098 form with the Internal Revenue Service to report the interest received.

Taxation as a Peer-to-Peer Lender

For a peer-to-peer lender, the interest that they receive is taxed as regular income. So, if a person making a loan falls into the 25% bracket, they would have to pay 25% of the interest that they receive in Federal income taxes. This puts peer-to-peer lending at a disadvantage relative to stock investing which receives preferable tax treatment for both capital gains and dividend income.

The tax consequences of peer-to-peer lending are less serious than they seem, though. With typical peer-to-peer lending returns in the neighborhood of 10 percent per year, even after the higher taxes they outstrip what the stock market delivers. In addition, savvy investors can use money in a Roth Individual Retirement Account (IRA) to engage in peer-to-peer lending. Since money in a Roth grows on a tax-free basis, the taxation penalty applied to the interest is negated. Alternately, they could use a traditional IRA to engage in peer-to-peer lending. While this does not eliminate the tax penalty, it defers it until the funds are withdrawn from the IRA, letting the money work harder while it is being lent.

Related or Unrelated

The tax information here applies to peer-to-peer loans made to unrelated parties. When a loan gets made between related parties, such as from mother to daughter, the Internal Revenue Service can treat the loan differently. In fact, it is possible that the lender would have to report the income while the borrower could not claim the interest as a deduction, even if they were entitled to it. Parties involved in peer-to-peer transactions with related people should consult an accountant for guidance.

Ultimately, peer-to-peer lending is an excellent option for both borrower and lender. From a tax perspective, it is no different from any other loan for the borrower. While it is different from other investments from a lender’s perspective, good tax strategy can help to maximize the already-generous returns from this investment class.

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