Many small businesses these days are borrowing from alternative or private lenders. If you’re a small business owner, you may find yourself wondering if you can deduct the interest on this type of loan from your federal taxes.
The short answer is—usually. The IRS wants to ensure your loan is a real business debt—not a gift or investment—and that the payments you’re making are genuine business expenses. The IRS requires three basic conditions for a business loan, regardless of the source:
Is your business legally liable for the debt?
Do both you and the lender agree that the loan will be repaid in full?
Does your business and the lender have a genuine debtor-creditor relationship?
The IRS will allow you to deduct interest paid on term and short term loans, lines of credit, equipment and inventory loans, merchant cash advances or loans for buying another business (if you manage the second business)—provided the loans qualify. The government will also let you deduct interest on personal loans that are completely used to fund your business or a portion of interest on a loan for mixed personal/business use.
However, if a loan comes from family or friends and/or you can’t show a legal agreement and a history of regular payments on a loan, or if the payments aren’t being processed by the lender, then you can’t claim the interest on your business taxes.
You also need to be able to show that the loan is being actively used for its intended purpose. You may need to show receipts or purchase agreements. If the money is sitting unused in a bank account, the IRS considers this an investment, not a loan. In addition, the IRS won’t allow interest deductions for:
Interest for an earlier loan which is paid using a new, second loan
Charges and fees for a commercial real estate loan
Capitalized interest (interest that’s part of a long-term asset and included in the depreciation)
Fees for funds kept on reserve in case they’re needed, such as a line of credit
As tax time approaches, you can be confident interest you’ve paid on a loan from a private lender will be deductible—provided the IRS is satisfied it’s a genuine loan.
Sources:
The Balance: Deducting Business Interest Expenses on Your Taxes: https://bit.ly/3X7hImf
Bank Rate: How to Write Off Repayment of a Business Loan: https://bit.ly/3jPgNs9
Forbes: Are Your Business Loans Tax Deductible?: https://bit.ly/3vNZURf
Internal Revenue Service: Publication 535 (2021), Business Expenses: https://bit.ly/3ZgsXKL
Nerd Wallet: Business Loan Interest Tax Deduction: https://bit.ly/3ZcVh0F
