In most cases, interest is a deductible expense on your business tax return and these expenses can include interest on loans, mortgages, and other business property. But there are some limitations on deducting these expenses based on 2017 tax law changes.
This article discusses what's deductible—and what's not—as business interest expense, and when this deduction might be limited for larger businesses.
- Small businesses can deduct expenses for interest on business loans if the loan shows legal liability and a true debtor-creditor relationship.
- There are limits on the amount of interest deductions a business can take, but small businesses are exempt from these limits if their income is below a specific level.
- If a business loan is used for different purposes, the interest expense must be allocated based on the types of use.
Types of Deductible Business Interest
Interest expenses are allocated based on their use. If you use a loan for more than one type of expense, you must allocate the interest expense based on the use of the proceeds. The possible categories of interest expenses are:
- For loans in the normal course of business
- For loans to buy property as a property rental business
- Loans for investment purposes
- Interest expenses on portfolio income (from dividends, annuities, or royalties)
- Loans for personal use (non-deductible)
Loan Interest on Business Activity
Businesses may deduct interest on loans taken out for business purposes, including mortgages on business property, term loans, and lines of credit.
The IRS says you may deduct interest on business loans if you meet certain requirements.
- Your business must be legally liable for that debt. If you are audited, you will need to provide the paperwork to show the terms of the debt and the signatures. For example, a UCC-1 statement is often required on loans, and a loan agreement should be in place.
- You need to show that you are making payments and that the lender is depositing those payments. A person-to-person loan with no activity might be suspect.
- You must be able to show a true debtor-creditor relationship, meaning that it must be an arms-length transaction. It's not just you and your brother who loaned you money and doesn't want to be repaid.
If your business borrows to purchase something, you will be charged interest on the balance, but there are some details you need to know about.
For mortgages on business property, you may decide to prepay interest from the settlement date to the closing date, as part of your closing costs. The IRS says that when you prepay interest, you must allocate the interest over the tax years to which the interest applies. You may deduct in each year only the interest that applies to that year.
If you take a loan to buy inventory for resale, the interest on that loan should be included in your cost of goods sold calculations.
Investment Interest Expense
If you borrow money to buy property you hold for investment, the interest on that loan is considered investment interest. Investment property includes property that produces interest, dividends, annuities, or royalties, but not in the ordinary course of business.
Generally, your deduction for investment interest expense is limited to your net investment income—that is, the interest expense cannot be greater than the income generated from the investment. However, you may be able to carry over excess interest expenses to a future year's taxes.
What's Not Deductible
You may not deduct interest that must be capitalized—meaning interest added to the principal balance of a loan or mortgage. This interest expense must be depreciated along with the other costs of the business asset.
Interest expenses for personal loans are not deductible in most cases. But if you have a loan for mixed business and personal expenses, you may deduct the portion that is for business purposes.
Small businesses can take a deduction for space in their homes used for a home business. But only the business part of these expenses used regularly and exclusively for business purposes can be deducted. Additionally, interest expense on a home loan can only be deducted for the business part of that expense.
Limitations Under Section 163(j)
Businesses can deduct interest expenses in full each year, For 2018 and beyond, business interest expenses for a year are limited to the sum of
- The taxpayer's business interest income
- 30% of the taxpayer's adjusted taxable income
- The taxpayer's floor plan financing interest expense (for auto dealers, for example)
In putting this limitation in place, the IRS also allows an exemption for small businesses that are not tax shelters, called a "gross receipts test." This test is met by businesses that have average annual gross receipts of $25 million or less in the previous three years. The $25 million is adjusted each each year for inflation.
Calculating the limitations on business interest can be complicated, and it should be done with the help of a licensed tax professional.
How To Claim Deductions for Business Interest
For sole proprietors and single-member LLCs, show these expenses in the "Expenses" section of Schedule C on Line 16. Note that interest expenses are divided between mortgage interest and all other interest expenses.
For partnerships and multiple-member LLCs, show these expenses in the "Other Deductions" section of Form 1065.
For corporations, show these expenses in the "Other Deductions" section of Form 1120.
For investment interest, use IRS Form 4952 to calculate the amount of the interest deduction.
Frequently Asked Questions (FAQs)
What is a business loan interest expense?
Interest expenses on business loans work the same way as interest on personal loans, except that the interest on business loans is a deductible expenses for the business, while interest on personal loans is not typically deductible. The types of business interest you can deduct include:
- Normal business loans
- Loans for passive income (for rental property, for example)
- Loans for investment purposes
- Investment portfolios
For small businesses, interest expenses include interest on loans for buying business property, including inventory, buildings, vehicles, and equipment. Make sure you have proper documentation of the loan in case of an audit.
There are limits on the amount of interest expense a business can deduct in a year, but small businesses are exempt from these limits if their average annual gross receipts for the previous three years is $25 million or less.
How do I claim interest on a personal loan used for business?
You typically can't mix business and personal expenses directly and a business can't claim interest deductions on a personal debt. You may be able to use funds from the personal loan as a loan to the business. You must have a loan agreement for the transaction with terms that show:
- Your business is legally liable for the debt
- Both your business and you (as the lender) intend that the debt be repaid
- Both parties have a true debtor-creditor relationship
The loan agreement should require repayment at a reasonable interest rate with repayments similar to other business loan terms. You may also need to prove that payments are being made regularly. With the loan agreement in place with the terms and conditions above, your business should be able able to deduct interest expenses.
This issue is best handled by a licensed tax attorney.