Are Your Business Loans Tax Deductible?
If you’re considering taking out a small business loan to fund a big project or replace that failing piece of equipment, you may wonder how that surge of capital affects next year’s taxes.
The good news is that most loans won’t materially alter what you owe in taxes. Receiving a lump sum in your bank account from a lender isn’t the same as earning money for your business, so that principle amount won’t be taxed.
The primary way that your tax responsibilities will change is in regards to the interest payments you make on your loan. Depending on the type of loan, as well as the legal structure of your business, you generally are able to deduct your interest payments and lower your tax burden.
Taking on a business loan will always carry risk, but the ability to write off your interest payments as business expenses should make the added cost a bit more palatable.
Is the interest on my business loan tax deductible?
Yes, for the most part, you can write off your business loan interest payments as a business expense. There are some qualifications your loan must meet, however, according to the IRS:
- You must be legally liable for the loan.
- You and the lender must agree that you intend to pay off the debt.
- And you and the lender have a true debtor-creditor, or lender-borrower, relationship.
Essentially, your loan must be a legitimate loan from a legitimate lender. You cannot borrow money from friends that you may or may not fully repay and deduct your interest payments to them.
Of course, this doesn’t mean you can’t borrow money from your friends or family if you’d like – just understand that they are not considered “real” lenders like banks or online lenders, and thus you won’t be able to deduct your interest payments. The reason for this is the IRS has no way of knowing if these informal agreements are just a way for you to avoid paying taxes.
Additionally, you have to actually spend the funds you’ve received on your business. If your loan just sits in your bank account, that’s considered an investment, not an expense – even if you’re making payments on the loan principal and its interest.
When is my interest not tax deductible?
There are certain exceptions to the rule that your business loan interest payments are tax deductible.
- When you refinance your business loan: You can’t deduct interest you pay with funds borrowed from the original lender through a second loan. Once you start making payments on the new loan, those interest payments are deductible.
- Points or loan origination fees: If you take out a loan to buy commercial real estate, the points, and loan origination fees cannot be deducted as business expenses—they have to be added to the value of the property and deducted over time with asset depreciation.
- Capitalization of interest: You can’t deduct capitalized interest, which is interest added onto the cost of a self-constructed, long-term asset.
- Fees incurred to have funds on standby: If you have funds available on a standby basis and your lender charges you a fee to keep them available, you cannot deduct them as interest payments.
What types of business loans have tax-deductible interest payments?
With exceptions that relate to your specific loan and how you’re using it, nearly every kind of small business loan will have interest payments that you can deduct. Let’s review how that would work for the most common types of business loans:
A term loan is a lump sum of funds that’s deposited in your bank account, which you pay back on a set schedule, with a set interest rate, over a period of months or years.
When you agree to a term loan, you will have a loan amortization schedule so you understand how much of each loan repayment is principle and how much is interest. Typically, term loans will be structured so you pay more interest towards the beginning of your repayment schedule, which means larger interest deductions are possible upfront.
However, you will likely pay interest every year that you are repaying your loan, so prepare to have loan deductions each year until you are debt-free.
SBA loans, which are term loans partially guaranteed by the Small Business Administration, function much the same way – and you can deduct your interest payments accordingly.
Lines of credit
A business line of credit is typically a revolving form of credit, allowing you to draw on a pool of pre-approved funds from you lender – similar to a credit card, but typically with much higher funding limits. You draw your funds, repay the draw on a schedule, and can draw again as needed.
Because you only pay interest on what you withdraw, your interest payment deductions will depend on how you use your LOC. Confirm with your lender what you pulled before filing your taxes.
Short-term loans are similar to regular term loans, with one obvious caveat: They have shorter repayment periods, oftentimes lasting less than a year. Therefore, you may deduct all the interest paid within the same annual tax filing.
Also, some short-term loans use a factor rate to determine interest payments, rather than an APR. Again, speak with your lender to determine your exact interest rate to know what you’ll be deducting come tax time.
You can use a personal loan to fund your business, and in some cases, people go this route to avoid having their business credit history scrutinized by lenders.
If you use your personal loan 100% to fund your business, your interest payments are deductible. If the loan is being used for mixed purposes, you can only deduct a portion of the interest. If you use a personal loan to buy a vehicle that you occasionally use for business, you can deduct a proportional percentage of the loan on your business taxes.
Loans for buying existing businesses
If you want to buy another business with the goal of actively running it, you might take out a loan to help you do so, and interest payments on that loan will be deductible.
If you want to buy another business but don’t expect to actively run it, that’s considered an investment, not a business expense. You may or may not be able to deduct interest on that loan, so speak to your accountant to see what your specific situation calls for.
Merchant cash advances
MCAs, where a lender advances you capital in exchange for a portion of each day’s credit card sales until you repay the debt, can have extremely high APRs and are often best saved as a last resort. Additionally, their “fees” aren’t technically interest payments, but purchases of your future receivables. Therefore, most CPAs can’t or won’t write your payments off on your return. You’re paying interest with none of the tax benefits of actual interest—so avoid this option if you can.
Taking on a small business loan should always be a net gain for your business – a means to achieve better results in the long run. That being said, there is certainly an upfront cost to them, and interest payments are the clearest example of that cost.
The fact that you can write those costs off as tax deductible is a huge benefit to small business owners, so make sure to discuss the tax ramifications with whatever product select with your accountant and team to make sure you are maximizing your tax savings.
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