Are Business Loans Tax Deductible?

Loans are a great way to fuel business growth, especially when you consider that business loans become tax deductible in the right situations. This article will guide you through how business loan tax deductions work, including how to qualify for these deductions, which loans are eligible, and which aren’t. This can help with your financial planning and control your tax liabilities, providing benefits to build your business further.  

How Does Business Loan Tax Deduction Work? 

When you’re looking to deduct business loans from your taxes, you need to understand that only the interest accrued on these loans is tax deductible, not the principal amount borrowed. The deduction is taken from your business’s taxable income, essentially reducing the total income subject to taxes.  

For example, if your business takes a loan with an annual interest payment (not the principal) of $10,000, this amount can be deducted from your total taxable income. This can significantly decrease the net cost of borrowing, making it a great option for businesses looking to expand or even manage cash flows more effectively.  

How Do I Know if I Qualify for a Business Loan Interest Tax Deduction? 

Meeting specific criteria – detailed in the upcoming sections – is important for qualifying for a business loan interest tax deduction. 

1. You must borrow from a business lender 

The first thing you need to qualify for a business loan interest tax deduction is that the loan must be obtained by a recognized business lender, like a bank or official lending institution. Loans from places like friends and family generally do not qualify because they cannot be officially verified and do not always come with formal lending agreements, which are required by tax authorities. Proper documentation, like a loan agreement or promissory note from a registered lender, is needed to prove the legitimacy of the loan and get the tax deductibility you’re looking for.  

2. You must spend your business loan 

For the interest on your business loan to be tax-deductible, the loan must be actively used for business-related expenses. Having the loan amount sit idle in a bank account will disqualify the interest from being deducted. Use the funds for operations or expenses directly related to the business, like purchasing equipment, funding inventory needs, or covering operational costs, to make the interest payments eligible for tax deduction.  

3. You’re legally liable for the debt. 

You must be legally liable for the debt to claim the deduction for your business loan interest. This will solidify the debtor-creditor relationship needed for tax purposes. A formal agreement like a promissory note should outline all the loan terms, including interest rates and repayment schedules. Additional terms could include convertibility of the debt into company stock or subordination clauses, which would give precedence to other creditors. These documents help formalize the financial arrangements and support the deduction eligibility during tax assessments. 

What Type of Loans Have Tax-Deductible Interest Payments? 

Several types of loans allow for tax-deductible interest payments. Different structures offer different opportunities, depending on how they are used and repaid. The following sections look at term loans, business lines of credit, and short-term loans, showing how each influences your tax situation.  

Term loans 

Term Loans give businesses a lump sum of capital, which is repaid over a set period – typically with a fixed or variable interest rate. The repayment schedule is often structured through an amortization structure, with each payment including both principal and interest. This is like an SBA loan, which also provides upfront sums and is paid back on a regular schedule. Again, for tax purposes, the interest portion of these payments is tax-deductible. For example, if a business pays $10,000 interest annually on a term loan, this amount can be deducted from each year’s taxable income. Note that principal payments are not tax deductible.  

Business lines of credit 

Business lines of credit are a more flexible financing option, where you have access to a pre-approved pool of funds that you can draw from as needed. They differ from term loans, as the interest is only charged on the amount of money used, not the total available credit. This can be advantageous for you if you want to manage your cash flow better. For instance, if you draw $50,000 from your line of credit which has $150,000 available, you pay back interest only on the drawn amount. If you accrue interest of $2,500 on the $50,000 draw, you can deduct that amount from the business’s taxable income for that year. 

Short-term loan 

Short-term loans are great for immediate business needs and are usually repaid within a year or less. They are different from traditional term loans basically due to their repayment period, and usually come with higher interest rates due to the increased risk to the lender. The interest on short-term loans is still tax-deductible if the funds are used for business purposes. The amount of interest paid can be significantly higher, reducing taxable income further. Some of the factors influencing the interest paid could be a lower credit score, bank or non-traditional lender rates, and size of the loan.  

Personal loans 

Personal loans are also used as a source of funding for business activities when traditional business financing options are not available. The tax implications are the same, you must use the funds for specific business purposes to get the tax deductibility. In addition, like business loans, only the interest portion is deductible. For instance, if a personal loan is used to purchase a car that is both for personal and business purposes, only the interest paid on the business use percentage is deductible. For example, if 60% of your car’s usage is for business, then 60% of the interest paid can be deducted from your business income.  

Loans for buying other businesses 

If you want to acquire another business through financing, the deductibility of the interest paid will depend on how the acquisition is treated – either as an active business operation or a passive investment. Interest expenses in the active management and operation of an acquired business can typically be deducted. However, interest on loans used to buy a business on a passive investment may not be as straightforward. For example, if a loan is used to buy out a competitor and integrate it into existing operations, the interest will typically be deductible. But, if the acquisition is more of an investment without direct involvement, the deductibility might not be applicable, so there will be more careful tax planning needed.  

When Can’t I Deduct My Interest? 

While most business loans can provide tax-deductible interest, not all types do. You as a business owner need to understand the specific conditions under which interest deductions are disallowed.  

Merchant Cash Advances 

Merchant cash advances (MCAs) are not traditional loans, but advances based on future credit card sales. They typically come with a high annual percentage rate (cost) as well. The cost of an MCA is calculated using a factor rate rather than an interest rate, which means the payments are ineligible for tax deductions. The repayment structure is usually directly tied to sales volume, which means there are unpredictable payment mounts, and you cannot deduct these costs as business loan interest on tax returns. This is a huge drawback for businesses relying on MCA. 

Refinancing Loans 

Refinancing business loans can affect deductibility of interest in complex ways. When a business pays off an existing loan with funds from a new loan, only the interest on the new loan can be potentially deductible. The key difference is the purpose of the debt – refinancing for a better interest rate or different terms can help preserve the deduction, but refinancing just to obtain additional funds can complicate or limit the tax benefits. Ensure you understand all the implications for refinancing for your tax deductions before doing so.  

Commercial Real Estate Loans 

Commercial real estate loans are generally not tax deductible because they are considered capital expenses rather than operational costs, similar to mortgages. The Internal Revenue Service (IRS) categorizes commercial real estate as a capital asset, excluding the deductibility of related expenses, including loan interest payments. However, other costs of owning commercial real estate, like property taxes, maintenance, and depreciation, are typically deductible. This aligns with the long-term investment nature of real estate, allowing businesses to gradually recuperate some costs through annual tax deductions while the property itself hopefully appreciates in value.  

Capitalized Interest Loans 

Capitalized interest loans allow you as a business owner to defer the interest payment by adding it to the loan’s principal balance. This arrangement is often found in construction loans or loans used for substantial business investments. For tax purposes, the capitalized interest is not immediately deductible; instead, it is typically amortized and deducted over the life of the financed asset. This means that the interest cost is spread across several tax years, aligning the deductions with the asset’s depreciation schedule.  

However, businesses need to understand that the IRS has specific rules regarding the capitalization and amortization of interest. These rules restrict the immediate tax benefits but align the financial reporting with the asset’s usage and value over time.