Finding ways to reduce taxable income is something that interests every business owner. If you, like many, have taken out a business loan, you may find yourself asking the question: “Are business loans tax deductible?” While the loan itself can’t be deducted, the interest from a loan is tax deductible. But there are limitations and restrictions as to how these deductions can be applied depending on how the loan was (or is) used.
In this piece, we’ll review tax-deductible interest on loans, how each loan type affects deduction and how you should claim your deductions.
What is Deductible Interest?
Tax-deductible interest is an expense you, as a borrower, may claim on a federal or state tax return. Many types of interest will reduce your taxable income, including interest on your mortgages (up to two properties), student loans, business loans and business credit cards. Non-business related debt interest, such as for an auto loan or personal credit card, can’t be deducted from your taxable income.
Capitalized interest—that is, interest added to the principal balance of a loan or mortgage—may not be deducted. This interest expense must be depreciated along with the other costs of the business asset.
Are Business Interest Expenses Tax Deductible?
Qualifying for a deduction requires your business to file a claim in the corresponding tax year that any interest accrued and has subsequently been paid for. This requirement covers all scenarios unless a specific exception is granted, or if the Section 163(j) limitation applies.
What is the Section 163(j) Limitation?
In 2017, The Tax Cuts and Jobs Act reconstructed Code Section 163(j), beginning in fiscal year 2018, enabling business organizations to write off net business interest expenses, excluding interest paid on investments.
As described by the IRS Tax Map, permissible deductions for a fiscal year are commonly limited to the total of:
- Business interest income
- 30 percent of the adjusted taxable income of the taxpayer
- And floor plan financing interest (used to purchase big-ticket items such as vehicles and boats used for display purposes)
If these thresholds are met, excess business interest can be carried forward and treated as “business interest paid or accrued” in the following tax year. Currently, there is no language in Section 163(j) preventing business owners from carrying future amounts forward indefinitely.
Are Business Loans Tax Deductible?
In short, yes, they are. However, there are a few stipulations your financing needs to meet before deducting any business loan interest.
The Funds Are Used for Business Purposes
It may sound strange, but spending funds that you’ve been loaned is important. The simple reason is due to the fact that if funds are still in your bank account, any interest you have paid on them is not tax deductible. Your business had a reason for securing a business loan, and the funds can’t help your business if they remain idle. Any funds that sit in your account are viewed as an investment by the IRS and therefore not eligible for a deduction.
You Are Legally Liable for the Debt
As long as you’re liable for the debt, you’re able to deduct any interest you have accrued and paid during the fiscal year. If you’re only liable for a portion of a debt, you may only deduct the interest you’re responsible for. To qualify for a business loan interest tax deduction, the paperwork you have on file for a loan needs to be in your name and reflective of the terms you’re reporting. For example, it’s common for a UCC-1 statement to be submitted with your tax return.
You and the Lender Expect the Debt to Be Paid Back
For your business loan interest to be tax deductible, you need to establish that you have been making regular payments and that your lender has been depositing them.
There is a True Debtor-Creditor Relationship
While this may seem straightforward, the IRS wants proof that the relationship between you and your lender is legitimate and not, for example, a handshake agreement between two individuals with one party providing a monetary favor for the other.
How Business Loans Affect Tax Deductions
Regardless of the type of small business loan you may have, the interest that is accrued against it can be deducted. In addition, how your business uses its funding will also impact your interest deduction eligibility.
To get a better understanding of how your small business loan might alter any potential deductions, let’s review how four common loan types treat tax deductions.
When you think of what a loan is, it’s likely that you’re thinking of a traditional term loan. Term loans are a one-time sum of capital that is repaid to the lender throughout the “term” (up to 5 years) through installments.
Interest rates on term loans are calculated on the remaining loan principal. You can deduct the interest you paid during that fiscal tax year, and you can continue to do so until your loan reaches maturity.
Similar to a term loan, a short-term loan also provides your company with working capital in a lump sum that is paid back in 18 months or less. Depending on the terms of your loan, qualifications and the preference of your lender, short-term loan interest can be calculated through a standard annual percentage rate (APR) or a factor rate. With the shorter payoff window, it’s likely that your deductions will be contained between one or two tax filings.
Business Lines of Credit
With a business line of credit, you withdraw what you need, up to the credit limit, and only pay interest on the amount you’ve used.
Since interest is paid only against the funds you withdraw, the size of your interest deduction depends solely on what you use. Due to its variable nature, be sure to double-check your statements before filing your taxes to make sure you’re working with up to date information.
Business Acquisition Loans
If you’ve used a loan to acquire a business, it’s likely that you’ll be able to deduct a portion, if not all, of the loan’s interest.
Deduction eligibility, in this case, comes down to your intentions for the business. If you’re purchasing the business with the intention of actively running it, you should be able to write off your interest. However, if you don’t plan on taking an active role in the business, the IRS will see this acquisition as an investment and will, therefore, restrict any deductible interest options you may have.
Investment expenses are interpreted differently by the IRS. From their standpoint, funds that have been invested into a business you’re inactive in typically would be generating money for you. Therefore, the interest on the loan you’ve secured to purchase the business would not be viewed as a business expense. If you find yourself faced with these decisions, we recommend consulting with your CPA.
How to File a Loan Tax Deduction
Now that you’re armed with the knowledge of what is and isn’t eligible for a loan tax deduction, you’re ready to include these itemizations in your tax filings. How you claim these deductions depends on how you’ve structured your business. Here is a quick breakdown on how each business organization needs to file their business loan interest deductions:
Sole Proprietors and Single-member LLCs
Show these expenses in the “Expenses” Section of Schedule C on Line 16b.
Partnerships and Multiple-member LLCs
Show these expenses in the “Other Deductions” Section of Form 1065.
Show interest expense tax deductibles for a corporation in the “Other Deductions” Section of Form 1120.
How to Make an Accurate Interest Tax Deduction Claim
Claiming the correct amount of interest you’ve paid (or will pay) on your tax return is a basic element of tax deduction claims. Compare your most recent statements from your lender with your end of year tax statement to check how much interest you paid for the year.
If you’d like to confirm what you see on your statements with your own calculations, there are plenty of online tools you can leverage to calculate your yearly interest burden.
Here is an example: Your lender charges you 9 percent interest on a $75,000 business loan with a 4-year term. The loan origination date is January 1. Throughout the loan, you will be able to itemize the following interest loan deductions:
Year 1: $5,218
Year 2: $4,823
Year 3: $3,174
Year 4: $1,371
The Last Word on Tax Deductible Interest
By learning that business loan payments are tax deductible, you can choose to invest in your business knowing you can reduce your taxable income. Whether you’ve taken a loan to purchase a business or to improve your current one, small business loans can benefit you in multiple ways.
Whenever you are deciding to secure small business funding, be sure to ask both your lender and your CPA if the terms you’ve been offered can be claimed as a business loan interest deduction. Doing this early in the loan process will help to determine if the terms are right for you and your business plans. Keeping up to date with the tax code, especially Section 163(j), will help you to keep as much money as you can in your business.