Interest you pay on business loans is usually a currently deductible business expense. It makes no difference whether you pay the interest on a bank loan, personal loan, credit card, line of credit, car loan, or real estate mortgage. Nor does it matter whether the collateral you used to get the loan was business or personal property. If you use the money for business purposes, the interest you pay to get that money is a deductible business expense. It’s how you use the money that counts, not how you get it.
Borrowed money is used for business when you buy something with the money that’s deductible as a business expense.
Example: Lie Dharma borrows $50,000 from the bank to buy new office equipments. He pays 6% interest on the loan. His annual interest expense is deductible as a business expense because the loan is a business loan.
Your deduction begins only when you spend the borrowed funds for business purposes. You get no business deduction for interest you pay on money that you keep in the bank. Money in the bank is considered an investment—at best, you might be able to deduct the interest you pay on the money as an investment expense.
If you are a homeowner and take the home office deduction, you can deduct the home office percentage of your home mortgage interest as a business expense.
If you use your car for business, you can deduct the interest that you pay on your car loan as an interest expense. You can take this deduction whether you deduct your car expenses using the actual expense method or the standard mileage rate, because the standard mileage rate does not include interest on a car loan.
If you use your car only for business, you can deduct all of the interest you pay. If you use it for both business and personal reasons, you can deduct the business percentage of the interest. For example, if you use your car 60% of the time for your Business, you can deduct 60% of the interest you pay on your car loan.
There is one important exception to this rule: Employees may not deduct car loan interest, even if they use the car for business.
Loans to Buy a Business
If you borrow money to buy an interest in an S corporation, partnership, or LLC, it’s wise to seek an accountant’s help to figure out how to deduct the interest on your loan. It must be allocated among the company’s assets, and, depending on what assets the business owns, the interest might be deductible as a business expense or an investment expense, which is more limited.
Interest on money you borrow to buy stock in a C corporation is always treated as investment interest. This is true even if the corporation is small (also called closely held) and its stock is not publicly traded.
Loans from Relatives and Friends
If you borrow money from a relative or friend and use it for business purposes, you may deduct the interest you pay on the loan as a business expense. However, the IRS is very suspicious of loans between family members and friends. You need to carefully document these transactions. Treat the loan like any other business loan: sign a promissory note, pay a reasonable rate of interest, and follow a repayment schedule. Keep your cancelled loan payment checks to prove you really paid the interest.
Interest You Cannot Deduct
You cannot deduct interest:
- on loans used for personal purposes
- on debts you or your Business don’t owe
- on overdue taxes (only C corporations can deduct this interest)
- that you pay with funds borrowed from the original lender through a second loan (but you can deduct the interest once you start making payments on the new loan)
- that you prepay if you’re a cash basis taxpayer (but you may deduct it the next year)
- on money borrowed to pay taxes or fund retirement plans, or
- on loans of more than $50,000 that are borrowed on a life insurance policy on yourself or another owner or employee of your business.
Points and other loan origination fees that you pay to get a mortgage on business property are not deductible business expenses. You must add these costs to the cost of the building and deduct them over time using depreciation.
Keeping Track of Borrowed Money
When you borrow money for your business, you should not deposit it in a personal bank account. Deposit it in a separate account for your Business. If you deposit a business loan in a personal account, you’ll have to be able to prove that the money was actually spent on business. Complex IRS allocation rules may have to be followed.
However, if you buy something for your business within 30 days of borrowing money, the IRS presumes that the payment was made from those loan proceeds (up to the amount of the loan proceeds). This is true regardless of the method or bank account you use to pay the business expense. If you receive the loan proceeds in cash, you can treat the payment as made on the date you receive the cash instead of the date you actually make the payment.