A business loan agreement is a two-way street; this document protects both you (the borrower) and the lender. Read on for everything you need to know before you sign on the dotted line.
Are Business Loan Payments Tax Deductible?
Depending on the type and structure of your loan, there are different options for what you can deduct from your taxes. We're breaking down the ins and outs of accounting for your loan payments during tax season.
If you took out a loan for your small business, you might be wondering if it’s tax deductible. Deducting payments is a savvy and financially smart practice that will save you money. When you deduct loan payments, the amount of money you are taxed on decreases, which makes your payments more affordable, decreases the cost of borrowing, and saves you tax dollars. Depending on the type and structure of your loan, there are different options for what you can deduct from your taxes.
First, let’s look at business 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.
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 true 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.
If you have a personal loan that you use for business, the same repayment idea applies, but requires a bit more consideration on your end. As with business loan payments, you can deduct interest payments on your personal loan. However, you can only deduct payments made on the money from the loan you used explicitly for your business. You cannot deduct interest payments on money you used for your personal purposes.
Similarly, you can deduct payments on personal credit cards, credit lines, cars, and real estate if they are connected to your business. For example, if you use your car for both business and personal travel, you can deduct payments based on the percentage of business use (determined by 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. 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.
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 impacts 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 that is 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 bought 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 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. 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) in order for you to be able to deduct your interest payments. IRS requirements include:
- 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.
- 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. Generally, payments that are not deductible include:
- If you refinance a loan and use your new loan to pay the interest on your old loan, 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.
- 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.” 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.
Our editorial content is intended for informational purposes only and is not written by a licensed insurance agent. Terms and conditions for rate and coverage may vary by class of business and state.