If you borrowed money for your small business, you might be wondering if it’s tax deductible. The answer is pretty consistent: you can only deduct the interest payments. However, that part is contingent on your loan and your business’s legal structure. The specific rules are explained in IRS publication 535.1
Why interest on a business loan is deductible
Borrowed money used on business expenses is what makes it tax deductible. If you are taking out the loan for business purposes such as buying new equipment or hiring additional workers, the interest you pay on the loan is a deductible business expense. What matters is how the money is used, not the type of loan.
Regulations on tax-deductible interest payments
The IRS has a few regulations and stipulations to permit you to write off interest payments on your loans:
- You have to be legally responsible for the loan.
- You and the lender have to agree that you will pay the entire loan and all the interest payments.
- The lender and borrower must have a true debtor-creditor or lender-borrower arrangement.
Basically, the IRS requires your loan to be an acceptable loan from an acceptable lender. This rules out loans from friends or relatives because they are not considered to be authentic lenders like banks or credit unions, making it a bit trickier to deduct interest. The IRS is worried that these informal loans may be a way to avoid taxes. To deduct the interest, it’s crucial to document these loans with the proper paperwork, such as a promissory with a fair rate of interest, and then follow a repayment schedule. It is also advisable to hold on to the cancelled loan payment checks to prove you reimbursed the interest to your friend or relative. Additionally, you have to actively spend the funds from the loan. If you take out a loan and just let the proceeds sit in a bank account, the IRS would classify that as an investment, not an expense—even if you are dutifully paying back the loan principal and interest each month.
Specific types of loans whose interest is deductible
Term Loans — As the name implies, term loans are bank loans with a set amount of time for repayment, normally from three to 10 years or even as long as 20 years. The loan can have a fixed interest rate or a floating rate. After signing the dotted line for the loan, the bank will give you a loan amortization schedule designating how much of the loan principal and interest you will pay each month.2 Typically, interest will be included in your monthly loan payments, so you will be able to deduct that amount each year until you pay off the loan.
Lines of Credit — The interest you pay on a business line of credit and then can deduct is a bit more complex to calculate than on the term loan. A line of credit issued by a financial institution is similar to a credit card since you can withdraw money from a pool of funds with a preset borrowing limit, but it usually has much larger funding limits than a credit card. With a line of credit, you only pay interest on withdrawals (i.e., if you have a $30,000 line of credit and only withdrew $5,000 in one calendar year), so it may be prudent to consult with your lender to determine how much interest you paid in a given year on the total repayments to the line of credit.
Short-term loans — Short-term loans work just like term loans but have shorter repayment periods, usually 18 months or less. Businesses seek these types of loans for immediate financing necessities. These loans can be attractive for a small business because they are simpler to attain than long-term business loans that may specify a higher credit rating or a long business track record. As a result, you may be able to deduct all the interest you paid in one annual tax return if the loan’s term was less than 12 months.
Personal Loans — Using personal loans for business expenses is a mixed bag. Some business people may prefer these loans if they prefer not to be subjected to the difficult process of having their business credit examined by a bank or other lender. However, you must monitor how you use these funds. If the entire loan is used for legitimate business expenses, then all the interest payments can be deducted. If you commingle proceeds from the fund for both business and personal you can only deduct the amount used for business, which may be difficult to track.
Merchant Cash Advances — Using merchant cash advances is not advisable if you want to deduct your interest payments. With these loans, a lender provides capital and receives part of a business’s daily credit card sales until the debt is reimbursed. These loans can have high interest rates and are probably best saved for an emergency when a company can not utilize other options. In addition, the money that the lender takes from the daily credit payments is not really interest, but acquisitions of a company’s future receivables. As a result, it may not be legal to claim those payments on your tax return so you lose out on the tax advantages for the interest you could have paid on other types of loans.
Tax deductions on business loans vs. personal loans
Whether you have a personal or business loan, the loan has two parts: the principal amount and the interest; these parts affect your taxes differently. Money used to pay the principal amount is never deductible from taxes, whereas interest payments can be.
Business Loans — In most cases, the interest you pay on your business loan is tax deductible. This is true for bank and credit union loans, car loans, credit card debt, lines of credit, and mortgage interest payments tied to your business. For example, say you pay $2,000 each month for your small business loan, and $1,500 goes towards paying down the principal amount, and you pay $500 in interest. While you cannot deduct the $1,500 payments you make on the principal loan amount, you can deduct the $500 a month you pay in interest. The same is valid for interest payments on your business credit card, business line of credit, business car loan, or any loan you’re taking out exclusively for a business expense.
Personal loans — If you have a personal loan that you use for business, the same repayment idea applies but requires a bit more consideration on your part. As with business loan payments, you can deduct interest payments on your personal loan. However, you can only deduct payments made on the funds from the loan you used explicitly for your business. Also, you cannot deduct interest payments on money you used for personal purposes. Similarly, you can deduct payments on personal credit cards, credit lines, cars, and real estate if they are connected to your business. Suppose you use your car for both business and personal travel.3 In that case, you can deduct payments based on the percentage of business use (determined by the number of miles driven for business purposes). So, if you use your car for business trips 60% of the time and personal trips 40% of the time, you can deduct 60% of the interest for the car loan. If you run your business out of your home, you can also deduct some of those expenses. For example, mortgage interest can be considered an expense.4 Like personal loan payments, the deduction must be split according to use. It’s important to keep track of your business and personal expenses so you can correctly separate expenses and accurately fill out your tax forms.
How loan structure affects deductions
The structure of your loan, whether business or personal, also impacts what you can deduct when it comes time to file taxes. Below are different types of loans, and how deducting their interest payments affects your taxes:
Credit Lines — You only pay interest on the funds you use each year, so you can only deduct interest payments on the money you used, not the total amount of credit available to you.
Expansion Loans — When you have an expansion loan, it is typically used to buy another business. If you run the new business you purchased with your expansion loan, you can deduct interest payments. However, if you do not run this new business, you cannot always deduct interest payments, as the new business is seen as an investment. You may be able to deduct these payments as investment expenses, but it is best to consult a tax expert.
Short-term Loans — With short-term loans, you are typically expected to repay the loan within a year so that you can deduct the entire interest amount. Therefore, you will receive a large deduction, which can help save your small business money.
Term Loans — A term loan with a long repayment period will typically require you to pay more interest upfront.5,6 Therefore, your tax deduction will be larger at first and decrease over time as your interest payment amounts decrease.
Additional IRS requirements
Your loan must meet requirements from the Internal Revenue Service (IRS) for you to be able to deduct your interest payments. IRS requirements include:7
- You are legally liable for your debt. Make sure you have paperwork for this transaction, such as the UCC-1 financing statement that a creditor files to give notice that it has an interest in the personal property of a debtor.8
- Intent to repay debt. You should have proof you are making payments and that the lender is depositing the funds.
- Have a true debtor-creditor relationship with your lender.
- It’s beneficial to have paperwork that details the relationship.
- Business-related spending. Use your loan on business expenses, not for personal purposes.
- Spend the money. As long as you spend the money you borrowed, you can deduct the interest on your business loan. If you put your loan in the bank and do not spend it, you may be able to deduct your interest payments as an investment expense.
If you’re unsure if your interest payments meet the qualifications for deductions, consult a tax expert.
While many interest payments are deductible, not all interest expenses associated with your business loan are deductible.9 Generally, payments that are not deductible include:
- If you refinance a loan and use your new loan to pay your old loan’s interest, you cannot claim the interest tax deduction on the old loan.
- Interest on loans for overdue taxes or tax penalties (you can only deduct this interest if you are a C-Corporation).
- Interest for loans of more than $50,000 that are borrowed against a life insurance policy for business owner(s) or employees. Interest for loans to pay taxes or fund retirement plans.
- Capitalized interest. This is the interest added to the total cost of a long-term loan or asset, and is not recognized as a current expense. Capitalized interest is considered a cost and not deductible.
- If your loan was forgiven under the Paycheck Protection Program, you cannot take deductions related to tax-exempt income.10
- Loan origination fees and basis points for commercial real estate are not considered deductible.
- Standby fees charged by lenders, which are not considered interest payments and therefore are not deductible.
For more detailed information on deductions, see IRS Publication 535 and make sure to scroll down to “What’s New for 2020.”11 Please note, this blog does not constitute tax planning advice. Be sure to consult your tax accountant for the latest updates on deducting interest expenses. Sources:
- IRS Publication 535 (2020), Business Expenses.
- Financial Calculations.com. Amortization Schedule
- IRS Publication 463, Travel Gift and Car Expenses.
- IRS 587 (2020), Business Use of Your Home.
- Investopedia, Term Loan.
- Colorado State University Extension, Long Term Replacement Methods
- IRS Publication 334 (2020), Tax Guide for Small Business
- Wikipedia, UCC-1 Financing Statement
- Nolo, “Deducting Business-Related Interest Loan Payments.”
- The Wall Street Journal “IRS Denies Tax Deductions Tied to Small-Business Loans.
- IRS “Publication 535 (2020), Business Expenses.