Deducting Business-Related Interest Loan Payments

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 for business real property. 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, 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.

For example, Max, the sole proprietor owner of a small construction company, borrows $50,000 from the bank to buy new construction equipment. He pays 6% interest on the loan. His annual interest is deductible on his Schedule C, Form 1040 because it is for a business loan.

When Does the Deduction Kick In?

Your deduction begins only when you spend the borrowed funds for business purposes. You get no business deduction for interest you pay on money you keep in the bank. Money in the bank is considered an investment.

Because interest on money you borrow for personal purposes—like buying clothes or taking vacations—isn't deductible, you should avoid paying this type of interest whenever possible. If you own a business, you can do this by borrowing money to pay your business expenses and then using the money your business earns to pay off your personal debt. By doing this, you "replace" your nondeductible personal interest expense with deductible business expenses.

Car Loans

If you use your car for business, you can deduct the interest 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 was not intended to encompass interest on a car loan.

If you use your car only for business, you can deduct all 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 business, you can deduct 60% of the interest you pay on your car loan.

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 either as a business expense or as 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 canceled loan payment checks to prove you really paid the interest.

Businesses That Earn Over $25 Million

Starting 2018, all businesses with average gross receipts of $25 million or more during the prior three years are allowed to deduct interest payments only up to 30% of their adjusted taxable income (income without including depreciation, interest expenses, NOLs). Any undeductible interest may be carried forward to be deducted in future years. However, real property and farming businesses may elect out of this prohibition and thereby deduct 100% of their interest expenses each year. To do so, they must depreciate their real property under longer periods—30 years (instead of 27.5) for residential property and 40 years (instead of 39) for nonresidential property.

Interest You Can't Deduct

You can't deduct interest:

• on loans used for personal purposes
• on debts your business doesn'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 aren't deductible business expenses. You must add these costs to the cost of the building and deduct them over time using depreciation. The same is true for interest on construction loans if you are in the business of building houses or other real property. Manufacturers of substantial amounts of goods—defined as goods worth $1 million or more and with an estimated production period of more than one year—must also depreciate the interest on money borrowed to produce their goods.

To learn more about what you can deduct, see Nolo's Business Deductions area.