Whether or not you can deduct from your taxes is determined by the structure and type of loan you have. In this article, we’re explaining the details of your loan payments and what to account for when filing taxes.
Deducting interest payments is a way to decrease your taxable income and can be applicable for many small business owners. Deducting loan interest payments saves you tax dollars because it lowers the amount of money you are taxed on in addition to the cost of borrowing. In order to reap these benefits, you must determine whether or not a loan you took out for your small business is tax deductible. Ultimately, there are options for how much you can deduct from taxes, dependent on the type and structure of your loan.
One thing to consider is personal loans vs. business loans. Both loans have two components that are important to note when understanding loan taxes: interest and principal amount. While interest payments can be deductible from taxes, you cannot deduct from the principal amount you pay.
Interest on a business loan is often tax deductible. This includes interest payments for credit card debt, bank and credit union loans, car loans, lines of credit, and mortgage interest payments related to your business. The principal amount is the amount of money borrowed that you agreed to pay back, and while interest can be tax deductible, the principal amount cannot be.
Personal loans that you use for expenses related to your business work similarly. Like business loans, interest payments on personal loans can be tax deductible as long as the payments are made on money you used specifically for your business purposes, rather than personal use. Transportation is a great example as many people make payments toward a car they use for both business travel and personal travel. By counting the number of miles you drive solely for work purposes, you can calculate the percentage of your loan put toward your car’s business use and determine how much you can deduct from there.
Types of Loans
How you deduct interest payments on different types of loans, both personal or business, can impact how you file taxes. Here’s how certain loans can affect taxes:
Short-term loans: Short term loans typically must be repaid by a specific date within a year of getting the loan. Because you can deduct the entire interest amount, you can save your small business money with a large deduction.
Term loans: Term loans that have longer repayment periods often demand more interest upfront. While your tax deduction is greater at first, it then reduces as your amount of interest payment decreases.
Expansion loans: Expansion loans are often used to buy additional businesses. You can deduct interest payments on this loan if you use it to run a new business purchased with the loan. If you do not run it, interest payments on the loan cannot always be deducted as the new business can be considered an investment.
Credit lines: Deductions on interest payments are only valid if the payments were made on money you used. You cannot deduct interest payments on the total amount of credit you have access to if you did not use it.
To deduct your interest payments, your loan must meet certain requirements from the IRS. These include:
Business-focused spending: Your loan must be used for business purposes, rather than personal use.
Money spent: You can deduct interest on money you spent from your business loan. If you did not spend your business loan, you can look into deducting your interest payments as an investment expense.
Debtor-creditor relationship: It’s helpful to use paperwork that recognizes that you and the lender have a true debtor-creditor relationship.
Legal liability for debt: You are legally liable for that debt. Have a creditor file paperwork to indicate that it has interest in the personal property of a debtor.
Intent to repay: Both you and the lender intend that the debt be repaid. Keep documentation of your payments and verification that the lender is depositing those payments.
Not all interest payments related to your business are deductible. Typically, these payments cannot be deducted:
Loan origination fees and basis points of commercial real estate.
Loans that were forgiven under the Paycheck Protection Program.
Loans for overdue taxes or tax penalties.
Loans that have been refinanced and used to pay interest on the initial loan. In this case, you cannot deduct interest on the old loan.
Interest for loans of more than $50,000 that are borrowed on a life insurance policy for business owner(s) or employees.
Capitalized interest, or interest toward the cost of a long-term loan.
Lenders’ standby fees.
Loans used to fund retirement plans.
Understanding tax deductions can be challenging as they depend largely on your specific loan type and use. Because specific rules can change year to year, we recommend you read the IRS Publication 535 the most up to date details on business expenses and deductions in 2020 and contact your tax advisor.