Business owners have a couple of dates to mark on their calendars during tax season: March 15 to file business taxes, and March 17 to blow off some steam at the local Irish pub. Unfortunately, we can only offer advice on the former, but we’ve got good news for business owners wondering “are small business loans tax deductible?” If you borrowed money this year, part of those small business loan payments is indeed deductible.
The Basics
Your loan payments are split between paying interest and pay down the loan principal. The part of your payment that goes toward interest is tax deductible, but there are no loan deductions for the part that goes toward paying off the capital.
So, for example, let’s say you pay $1,000 a month for a business loan. $300 goes to interest while $700 goes toward the loan principal. You can deduct the $300 a month for interest, but the rest will not be tax deductible.
When you make the deduction, it lowers the amount of money you pay taxes on. This is not the same thing as lowering your tax bill by the amount of the deduction. For example, if you paid $3,600 a year in interest ($300×12) and planned to report $100,000 in income on your taxes, the figure would fall to $96,400 after the deduction. Assuming you pay a 21% tax rate, your bill would be $20,244 (with deducted interest) compared to $21,000 (without deducted interest), a difference of $756. You won’t save as much as you deduct, but making small business loan payments tax deductible is still a significant economic boost.
The Fine Print
In addition, your loan payments are tax deductible only if you meet the following requirements. You must:
- Be legally responsible for the debt and have a signed contract.
- Intend to pay the money back.
- Have a true debtor-creditor relationship with the lender. If you borrow from a friend or family member, make sure to use a signed promissory note listing the interest rate and follow a clear repayment schedule. Otherwise, the IRS may deny your deduction.
- Spend the loan proceeds on something for your business. If you just keep the money in the bank, you cannot take the tax deduction.
The Exceptions
Answering the question “Are business loans tax deductible?” is complicated because there are loan arrangements where the interest cannot be deducted from your business taxes. You need to be aware of these exceptions before entering into any loan agreement:
- Refinanced Loans – If you take out a second loan from the same lender and use those funds to pay the interest on the first loan, the interest is no longer deductible. However, you can still deduct the interest you pay on the second loan.
- Commercial Real Estate – If you use financing to purchase commercial real estate, the loan origination fees and basis points cannot be deducted as business expenses. Instead, you’re required to include these in the overall cost of the property. Over time, you can deduct them as part of asset depreciation.
- Capitalized Interest – If you rely on loans to finance the construction of a long-term asset, most likely a building, the capitalized interest must be added to the cost of the property rather than deducted from your tax bill.
- Standby Fees – If your lender charges you a fee to keep the funds on standby, the IRS does not recognize this fee as a form of interest payment, meaning it can’t be deducted.
The Examples
Are business loan payments tax deductible for all types of loans? The good news is yes, basically any kind of business loan that involves interest allows for some kind of deduction. To help you get the most tax assistance possible, consider how these deductions apply to common loan examples:
- Term Loans – Loans with a long repayment period are typically structured so you pay more interest upfront, meaning your deduction will be larger at first but get smaller over time. The advantage is that you receive a yearly deduction for as long as you’re paying interest.
- Credit Lines – When a lender makes a line of credit available to you on-demand, you only pay interest (and receive a deduction) on the funds you draw out in any given year. Depending on your business needs and tax burden, having an accessible funding source could work to your strategic advantage.
- Short-Term Loans – If you are required to pay back a loan within a year, as is common of many small business loans, you can deduct the entire interest amount from your taxes. Much like a line of credit, savvy business owners can use this large tax deduction to bolster their bottom line.
- Personal Loans – As long as personal loans are properly reported (as outlined above) the interest us fully deductible. If they are split between business and personal use, the deduction must be split accordingly.
- Expansion Loans – Loans are often used to buy another business. If you intend to run the business, the loan interest is deductible. If you don’t intend to run it, your involvement is considered an “investment” and the interest may not be tax deductible. In this instance, it’s best to ask a tax professional.
Are small business loans tax deductible? In most cases, yes. By taking advantage of this tax deduction, your loan payments will be a little more affordable and your next tax return a little less, well, taxing. To maximize your tax deductions, read our blog about small business tax deductions.
