Is the Loan I Used to Buy My Small Business Tax Deductible?

Buying a small business is a significant financial commitment, and if you’ve taken out a loan to buy your small business, you’ve incurred a significant amount of personal and financial risk. As a result, you may be wondering whether the interest on that loan is tax-deductible. Understanding the tax implications of the loan used for purchasing your business is a key step for any new or prospective small business owner.

Why does Loan Interest Deductibility Matter?

Here's why the deductibility of your loan interest is so important:

At the end of the day, being in business is about cash flow. You probably don’t have dreams of working for free. If your loan interest isn’t deductible, you wind up paying taxes on the interest that you owe to the bank. Deductible loan interest means more cash flow, which means more dollars in your pocket as you start your new business venture.

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Is the interest on my small business acquisition loan deductible?

To oversimplify things, yes, the IRS allows business owners to deduct interest payments on loans used for business purposes. This includes loans taken out to purchase an existing business. The key factor is that the loan must be used for business purposes and only applies to your interest payments, not principal payments. If the loan is used solely for acquiring the business and running its operations, the interest is typically tax-deductible. However, there are several more rules to consider.

Allocation of Loan Interest

The first item that governs your loan interest’s deductibility is how you used your funds. This is governed by §1.163-8T.  If you used the loan solely to buy a business, your interest will be tax-deductible. However, if you used your loan for both business and personal purposes, you’ll need to allocate the funds appropriately. Only the portion of the loan used for business activities is eligible for the interest deduction. For example, if you borrowed $100,000, used $80,000 for buying the business, and $20,000 for personal expenses, only the interest on the $80,000 is deductible. This is called loan interest tracing and applies to any future loans you may take to operate the business.

Luckily, most of you reading this article will be interested in buying a business and putting the money to productive use, not taking a loan out for personal expenses!

Did you use your loan to buy into a business that is a “Passive” activity?

The second rule to be aware of is the IRS’s passive activity rule, which can limit your ability to deduct losses from passive activities. If you’re buying a business that you won’t actively participate in, the loan interest may be considered part of a passive activity. In this case, your ability to deduct the interest may be limited, especially if you don’t have other passive income to offset it.

In essence, what this means is that the loan interest can offset the income generated by your passive activity. However, if the business is run at a loss, the losses CANNOT offset your other active income. This interest would first be entered on Form 8582 before flowing through to the appropriate schedule.

How to report the loan interest on your small business acquisition loan

Now that you’ve established that your business interest is deductible, you need to know where to report the loan interest on your tax return. Typically, people wrap their loan interest into their business and report it as a regular business expense on their Schedule C or Schedule E depending on the type of entity.

However, loan interest used in the purchase of a pass-through entity is different. According to IRS Notice 88-37, the loan interest should be broken out in a separate line on part II of Schedule E or Schedule A. The expense should be labeled as “business interest” followed by the name of the business that you purchased.

This results in there being two items on a Schedule E – one positive (hopefully!) item for business income and one negative line item for loan interest. The above example shows how this could be done for an entity that flows through to Schedule E.

Taking the time to do this the right way will allow you to recognize the correct deductions, lower your tax bill, and reduce the chances of errors being found during an audit.

Conclusion

The loan interest on a loan used to buy a small business can be tax-deductible, as long as the loan is used for business purposes. However, the application of this deduction can be complex depending on how the loan is used, the structure of the business acquisition, and your involvement in the business.

When you shift from being a W-2 employee to being a full-time business owner, things get complicated. To fully understand your tax obligations and opportunities, it’s best to seek advice from a tax professional who can tailor their guidance to your unique circumstances.

Navigating the tax landscape as a business owner can be challenging, but with the right knowledge and professional advice, you can ensure that you’re making the most of your new business.

Ironclad Wealth Management is a full-service financial planning firm that helps business owners reduce their taxes to reach their financial goals faster. Want to learn more?

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