Interest Loan Payment Deductions Under Business Tax Law
A business owner generally can deduct any interest that they pay on business loans from their taxes. However, you can claim the deduction only if you spend the money from the loan for a business purpose. If you keep the loan in a bank, it will be classified as an investment and will not support a deduction. You cannot claim a deduction for interest on personal loans. As a result, a business owner should get a loan for their business and then pay off personal debts from business profits.
There is an exception for businesses that accumulate annual gross receipts of $25 million on average during a three-year period. If your business fits into this category, you can deduct interest payments on a business loan only up to 30 percent of the adjusted taxable income of the business. (Adjusted taxable income does not take depreciation, net operating losses, and interest expenses into account.) If the interest exceeds this amount, you can deduct it in future years. There are some exceptions to this exception for businesses that involve real estate or farming, as long as they depreciate their real estate over a longer period.
Common Types of Loans
Many business owners take out a loan to buy a new business, whether this is a partnership, a corporation, or a limited liability partnership or corporation. The interest on your loan might be classified as a business expense or an investment expense. The types of assets that the business owns will determine how it is classified. You will find it easier to deduct the interest if it is classified as a business expense. If you take out a loan to buy a C corporation, this will be classified as an investment expense, regardless of the size of the corporation and how its stock is traded.
Ask an Expert
It may be helpful to consult a professional, like an accountant, to determine whether interest is a business expense or an investment expense.
Another common type of loan that a business owner might take out is a car loan for a business vehicle. If the car is used only for business purposes, they can deduct all of the interest on the loan as a business expense. Many business owners use a car for a combination of business and personal purposes, though. They can deduct the percentage of the interest that corresponds to the percentage of their business use of the car as a business expense. If they use the car for business 70 percent of the time, for example, they can deduct 70 percent of the interest.
Red flags tend to arise when a business owner gets a loan from a friend or a family member. Technically, they still can deduct the interest on this type of loan as a business expense. The IRS may examine the nature of the loan more closely, which means that the business owner should keep thorough records regarding the loan. You should complete the same type of promissory note that you would for a standard loan, and you should not ask your friend or family member for an excessively low interest rate. You should keep up with payments on the loan and observe any other formalities.
Interest Not Eligible for Deduction
Not every type of interest can be deducted on your taxes. For example, you cannot deduct interest on loans that you took out to pay taxes or put money into a retirement plan. You also cannot deduct interest on debts that your business does not actually owe or interest paid through a second loan from the original lender. (You can start claiming a deduction for this interest once you start paying off the second loan.) Unless you are running a C corporation, you cannot deduct interest on overdue taxes. If you are a cash basis taxpayer, you will need to wait to deduct any prepaid interest until the following year. You also cannot deduct interest if you took out a loan of more than $50,000 based on your life insurance policy or the life insurance policy of someone else who is involved in the business.
Only interest on loan money actually spent on business expenses is deductible, not loan money sitting in a bank account.
Using Depreciation for Certain Types of Interest
You cannot deduct loan origination fees for mortgages on business real estate. However, you can spread the deduction for the loan origination fees over multiple years through the depreciation process by adding them to the cost of the real estate. If your business involves building houses or other structures, you cannot deduct interest on construction loans but can potentially use depreciation instead.