Business Loan Interest Tax Deduction: What Small-Business Owners Need to Know
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If you’re a small-business owner who’s taken out a loan to grow your business, you might be worried about paying it off — especially with the interest on top. Here's some good news for you: The interest on your business loan is tax-deductible as a business expense.
Well, mostly. To be eligible, you’ll need to meet some criteria as defined by the Internal Revenue Service:
You and the lender have a true lender-debtor relationship (i.e., not family and friends).
You’re legally liable for the debt.
Both you and the lender intend for the debt to be repaid.
Here’s what you need to know.
Do you qualify for a business loan interest tax deduction?
These two qualifications should help you figure out if the interest on your business loan is tax-deductible:
1. You have to borrow from a 'real' business lender
This might sound overly simplistic, but it’s so basic that it’s worth reiterating. In order to qualify for a business loan interest tax deduction, your business loan has to come from a true lender, such as a bank or other liable lender. So, even if you’re a startup that’s taken initial funding from friends and family who are charging you for the cash, you probably won’t be able to write off this type of interest.
Why? The IRS is very suspicious of loans between family and friends because, often, these loans are issued informally. Family and friends may not charge appropriate interest or even require full repayment, which would make the funds issued a gift rather than a loan. And that’s a different tax structure entirely.
To consider your loan valid, the IRS wants to see that you are legally liable for the debt, have the intention to pay off the debt and that you have a clear repayment schedule.
If you’re interested in lowering your tax burden by deducting the interest on a business loan from a family member or friend, detailed documentation will be critical. This includes a promissory note signed by both parties at the origination of the loan, repayment at a similar rate of interest to what you’d pay to a bank or traditional lender and keeping detailed records of all payments.
2. You have to actually spend your business loan
The other important distinction to note when figuring out business loan interest tax deductions is whether or not you’ve spent the loaned funds.
If the funds from your business loan are just sitting in your business bank account, the interest isn’t tax-deductible. Even if you’re paying off the principal and interest of your loan. You have to actually use the cash you’ve been issued in order to be eligible for the deduction. Money that is left in the bank and goes unspent is considered an investment and not an expense, which is why that interest isn’t tax-deductible.
Types of business loans and how to handle their interest deduction
In general, it’s likely that some amount of interest on a small-business loan for which funds are being used for a true business purpose can be deducted, regardless of the type of loan. This is awesome for you as a business owner. How much interest and when you can deduct it will depend on how interest on the loan is calculated and when the loan is repaid and a few other details around its use case.
Of course, as with anything else in the tax code, not every situation is cut and dry for deducting loan interest. There are exceptions in certain cases that might impact whether the interest on your business loan is tax-deductible — most often relating to your use of loaned funds.
We’ll take a look at some of the most common business loan types to consider how tax deductions would apply to business loan interest in various scenarios. But, as always, you’ll want to talk to your business accountant to determine whether or to what extent you can deduct interest on your business loan.
This is generally what you think of when you think of a business loan. Term loans are typically issued as a lump sum deposited directly into a business owner’s account. Loaned funds are paid off on a set schedule — typically monthly, depending on your terms with your lender — over a number of years.
Interest on term loans accrues at a set rate over time. That interest on term loans typically compounds with every repayment period — you can use a loan amortization schedule to determine the exact amount of interest in each period.
As a general rule, interest on a term loan is deducted in the corresponding year that payments were made. This means if you take out a term loan with a three-year repayment period, you will deduct the interest paid in each of three consecutive tax years, with the amount deducted reflecting the amount you paid on interest in each of those years.
If you have an SBA loan structured as a term loan, you can apply these same principles to estimating tax deductions on your SBA loan, too.
Business lines of credit
Like a term loan meets a business credit card, a business line of credit allows you to draw from a pre-approved maximum amount of available funds as needed. Then, you repay the amount withdrawn as you’re able (within certain minimum repayment guidelines). You pay interest only on the amount you use, unlike a term loan.
Since interest on a business line of credit accrues only when you draw from it, the amount of your interest deduction will depend upon your usage. Before filing your annual business taxes, reference the statements on your business line of credit account just as you would for your business credit card account to determine the total amount of interest paid. You can always chat with your lender to find out what, exactly, you’ve used, too.
As the name suggests, short-term loans tend to be repaid over a shorter period of time than other loan types — often within the same tax year. This means you’ll likely deduct all interest paid either within the same annual tax filing or split between two annual filings.
The interest on your short-term loan may be calculated using a standard annual percentage rate (APR) or a factor rate, depending on the terms of your individual loan. This will depend on your lender. The method of calculation will impact the amount of interest you pay, and therefore the amount you can deduct from your taxes. So, you’ll want to talk to your individual lender to determine your interest paid before filing your taxes.
This isn’t a business loan, yes — but if you’re using a personal loan for business, this is relevant.
If a personal loan is being used for mixed purposes, like a car loan with the car split between business and personal use, then the portion of the interest that’s deductible is proportional. For example, if only 5% of your time spent using your car is for your business, you’ll be able to deduct 5% of the loan interest. This is similar to mortgage interest if you use a portion of your home for your business, like a dedicated home office.
Loans for buying other businesses
If you take out a loan to buy another business, you will likely be able to deduct some or all of the loan interest. If you get a loan to help you purchase another business with the goal of actively running the business, then you should be able to deduct interest expenses.
If you get a loan to help you purchase a business, but don’t plan on actively participating in the business, the IRS will consider that as an investment. You’ll generally still be able to deduct interest that you pay on that loan, but might face more restrictions. There are more restrictions and limitations around investment interest, so it’s a good idea to discuss this with your accountant.
All of this mostly depends on whether or not the purchase is considered an investment expense. That’s because interest on investment expenses is treated differently than interest on traditional term loans. In the eyes of the IRS, your business would typically be making money on invested funds — so, the interest shouldn’t be treated as a business expense. If that’s the case, keep in mind that you won’t be able to deduct more interest than income generated from the investment. You can, however, carry over interest to future years.
Since this is a sort of sticky one, you’ll definitely want to make sure you consult with your accountant here to determine how the tax code applies in your specific situation.
Business loan interest tax deductions: Special cases
Although there are many cases in which interest on business loans is tax-deductible, there are some situations in which it isn’t:
If you refinance your original business loan
If you’re in an advantageous position to get a lower interest rate or a better repayment term, you might choose to refinance your business loan. That’ll save you money in the long run! It’s important to note, though, that if you pay off a loan to the original lender with funds from a second loan, that’s not considered a business expense. This means that the interest you pay to the first lender isn’t tax-deductible.
Once you begin paying off the new loan, however, you can begin to deduct the interest again.
Points or loan origination fees
If you take out a loan to purchase a business property, the points and loan origination fees aren’t considered business expenses and can’t be deducted. These costs must be added to the value of the property and deducted over time with asset depreciation. This is also true for construction business loans and manufacturing loans for businesses with goods worth more than $1 million.
So, is interest on a business loan tax-deductible? Mostly
Although there are some specific situations in which you might be limited in how much interest you can deduct, the answer is mostly yes. If your loan is being used for business purposes, then the interest is tax-deductible. There are some situations that are a little trickier and more technical than others, though.
As always, it's good to have an accountant on your side who understands the nuances of your business and finances.
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A version of this article was first published on Fundera, a subsidiary of NerdWallet.