If you’re considering taking out a small business loan to fund a big project or replace that failing piece of equipment, you may wonder how that surge of capital affects next year’s taxes.
The good news is that most loans won’t materially alter what you owe in taxes. Receiving a lump sum in your bank account from a lender isn’t the same as earning money for your business, so that principle amount won’t be taxed.
The primary way that your tax responsibilities will change is in regards to the interest payments you make on your loan. Depending on the type of loan, as well as the legal structure of your business, you generally are able to deduct your interest payments and lower your tax burden.
Taking on a business loan will always carry risk, but the ability to write off your interest payments as business expenses should make the added cost a bit more palatable.
Taking out a business loan can provide vital funding to start or grow your company. But when it comes time to repay the loan, many business owners wonder – is the repayment taxable?
The short answer is no, a business loan repayment is generally not considered taxable income. However there are some nuances to understand regarding the tax implications of business loan repayment.
In this comprehensive guide we’ll cover
- Why business loan repayment is not taxed
- The interest deduction on business loans
- Limits on interest deductions
- Using loan funds for deductible expenses
- Reporting business loan repayment on your taxes
- Frequently asked questions
Let’s dive in!
Why Business Loan Repayment is Not Taxed
When you take out a business loan, the loan proceeds are not considered taxable income. This is because you have an obligation to pay the money back. It’s not free cash that counts as revenue for your business.
Similarly, when you repay the principal on a business loan, those payments are not deductible. You are simply paying back money you borrowed, not spending money in a way that can be written off.
The IRS does not consider principal repayments on business loans to be expenses. Rather, the principal payments are considered reductions in your loan liability.
In short, business loan repayment is not taxed because:
- The loan itself is not income
- Principal repayments are not business expenses
- You’re paying back money you borrowed, not spending new money
However, the interest portion of your loan payments may be tax deductible, which we’ll explain next.
The Interest Deduction on Business Loans
While principal repayments on a business loan are not deductible, the interest portion of your payments is likely tax deductible.
This interest can usually be deducted as a business expense, reducing your taxable income.
For example, let’s say you take out a $100,000 business loan at 6% interest over 5 years. Your monthly payments are $1,910. Of that, about $458 goes toward interest while the rest pays down principal.
You could deduct that $458 in monthly interest as a business expense. Over the life of the loan, you could deduct around $27,480 in total interest payments.
To qualify for the interest deduction, the loan must meet certain criteria:
- You must be legally liable for the debt
- You must make actual payments on the loan
- The loan must be for legitimate business purposes
- You must keep records of interest paid
As long as you meet these requirements, the interest can be deducted as an ordinary business expense on Schedule C for sole proprietors or Schedule F for farmers.
Limits on Business Loan Interest Deductions
While business loan interest is usually tax deductible, there are some limits in place:
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Investment interest limits – Interest on loans used for investment purposes is limited to your net investment income for the year. Any excess interest gets carried forward.
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At-risk limits – Interest deductions on loans for some activities like farming may be limited to the amount you have personally invested or are liable for.
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Passive activity limits – If the loan is used for a passive activity like a rental property, deductions may be limited to passive income from that activity.
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Excess business interest limits – For very large loans, interest deduction may be limited to 30% of your business’s adjusted taxable income.
So while the bulk of interest on business loans can be deducted, work with a tax professional to determine if any limitations apply to your particular situation.
Using Loan Funds for Deductible Expenses
Above we explained that principal repayments on a business loan cannot be deducted. However, if the loan funds were used for deductible business expenses, those may be written off.
Some examples of deductible expenses that could be paid with a business loan include:
- Equipment, machinery, vehicles, or furniture
- Renovations or repairs on a building
- Inventory and supplies
- Marketing, advertising, or research expenses
- Software, subscriptions, or other services
- Professional fees like legal or accounting
- Salaries, contractor payments, and other labor costs
To claim these expenses, be sure to keep detailed records showing how the loan funds were used. Work with your accountant to determine which types of purchases or payments are deductible.
Pro tip: Consider timing larger equipment purchases or renovations to coincide with when you receive loan disbursements. That maximizes your potential deductions.
Reporting Business Loan Repayment on Your Taxes
Come tax time, how should you report business loan repayment on your tax return? Here are some tips:
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Provide your accountant with documentation of the original loan terms, including the interest rate, fees, payment schedule, and purpose of the loan.
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Supply documentation showing your actual loan payments for the year, separating the amounts for principal vs. interest. The 1098 form your lender issues will help with this.
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Note any loan funds used for specific deductible expenses like equipment purchases. Provide invoices showing the amounts.
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If you made deductible expenses using personal funds, note those as well. Don’t accidentally deduct expenses made with business loan funds.
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Review any limits on deducting interest, particularly if loan amounts are over $750,000. Prorate expenses appropriately.
With good documentation and clean accounting, your tax preparer can ensure loan repayments are handled correctly. The interest deduction could yield big tax savings.
Frequently Asked Questions
Can I deduct principal repayments on my business loan?
No, repayment of loan principal is not considered a business expense, so you cannot deduct principal payments on a business loan. Only the interest portion of your payments is deductible.
Are SBA loan payments tax deductible?
With SBA-backed loans, the same rules apply. The principal repayments are not deductible, but the interest portion can be deducted as a business expense.
Can I deduct early repayment or fees?
Unfortunately fees and penalties for early repayment are not tax deductible. While interest payments are deductible, the principal portion of payments cannot be deducted even if paying down debt ahead of schedule.
Is forgiven PPP loan repayment taxable?
Yes, if you receive loan forgiveness on a PPP loan, that canceled debt is taxable income. So you would need to claim the forgiven amount as income on your tax return.
Should I ask my accountant about business loan repayment?
Yes, it’s smart to consult a tax professional to ensure you maximize deductions appropriately and handle business loan repayment correctly on your taxes. An accountant can advise on deduction limits and documentation needed.
The Bottom Line
When structured properly, a business loan can provide capital to take your company to the next level, while also offering some tax benefits.
Understanding the tax implications involved can help you get the most from your business financing. While principal repayments are not deductible, the interest payments on a business loan are likely tax deductible as an ordinary business expense.
With good record keeping and accounting, you can reap rewards at tax time. Just be sure to work with an accountant to handle the details accurately based on your situation.
What Types Of Business Loans Have Tax-Deductible Interest Payments?
With exceptions that relate to your specific loan and how you’re using it, nearly every kind of small business loan will have interest payments that you can deduct. Let’s review how that would work for the most common types of business loans:
A term loan is a lump sum of funds that’s deposited in your bank account, which you pay back on a set schedule, with a set interest rate, over a period of months or years.
When you agree to a term loan, you will have a loan amortization schedule so you understand how much of each loan repayment is principle and how much is interest. Typically, term loans will be structured so you pay more interest towards the beginning of your repayment schedule, which means larger interest deductions are possible upfront.
However, you will likely pay interest every year that you are repaying your loan, so prepare to have loan deductions each year until you are debt-free.
SBA loans, which are term loans partially guaranteed by the Small Business Administration, function much the same way—and you can deduct your interest payments accordingly.
When Is My Interest Not Tax Deductible?
There are certain exceptions to the rule that your business loan interest payments are tax deductible.
- When you refinance your business loan: You can’t deduct interest you pay with funds borrowed from the original lender through a second loan. Once you start making payments on the new loan, those interest payments are deductible.
- Points or loan origination fees: If you take out a loan to buy commercial real estate, the points and loan origination fees cannot be deducted as business expenses—they have to be added to the value of the property and deducted over time with asset depreciation.
- Capitalization of interest: You can’t deduct capitalized interest, which is interest added onto the cost of a self-constructed, long-term asset.
- Fees incurred to have funds on standby: If you have funds available on a standby basis and your lender charges you a fee to keep them available, you cannot deduct them as interest payments.