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Taking out a loan can keep a small business afloat, but when tax time comes, you might ask which parts of your payments lower your tax bill. In corporate tax accounting, distinguishing deductible interest from nondeductible principal affects your tax return, cash flow, and future borrowing. This article explains how interest expense, loan origination fees, amortization, and refinancing can influence deductions on forms like Schedule C so you know when a payment is a tax write off. Want clear rules on whether business loan payments are tax-deductible and how the IRS treats interest versus principal?
To answer that question, Haven offers accounting services for small businesses that track loan interest, classify payments correctly, and help you claim every legitimate deduction without the guesswork.
Table of Contents
What Part of Business Loan Payments Are Deductible?
When you make a loan payment, the principal portion repays borrowed capital and is not deductible. The interest portion is a business expense and is generally deductible when the loan proceeds fund business activity. Lenders give an amortization schedule that separates principal and interest so you can determine the deductible amount.
Real World Example: Breaking Down a Monthly Payment
Imagine a $1,200 monthly payment where $840 reduces principal and $360 is interest. You can deduct only the $360 as interest expense on your profit and loss statement. Track each monthly statement so the annual total of interest paid is correct for the return.
Who Qualifies to Claim the Deduction and Why Use of Proceeds Matters
You or your business must be legally liable on the loan, and the funds must have been used for business purposes to claim interest as a deductible expense. If a personal loan was used entirely for business, you can allocate and deduct the business portion. For mixed use, you must divide interest between personal and business use and document the allocation.
Accounting Method: Cash Basis Versus Accrual Basis Treatment
Cash basis taxpayers deduct interest when paid. Accrual basis taxpayers deduct interest when it is incurred, even if not yet paid. Accrual taxpayers should track accrued interest on the balance sheet and reconcile that to interest expense on the income statement.
Mixed Use Loans and Allocation Rules
When a loan funds both business and personal purchases, only the business use portion is deductible. Common examples include vehicles and homes used for work. Use mileage logs, receipts, bank transfers, and invoices to support the percentage allocated to business.
Loan Fees, Points, and Prepayment Penalties: How to Treat Extra Charges
Origination fees and loan points are usually treated as part of the cost of borrowing and are amortized over the life of the loan unless tax rules allow immediate deduction. Prepayment penalties and late fees that are effectively interest are deductible when paid. Ask the lender for an itemized statement showing fee types and dates.
Business Interest Limitations Under Section 163(j)
The tax code limits business interest deductions for many taxpayers to business interest income plus a percentage of adjusted taxable income. Small businesses with average annual gross receipts below the IRS threshold are generally exempt from that limit. Real property businesses can elect out of the rule if they meet special requirements and use an alternate depreciation method.
Related Party Loans and Below-Market Interest Issues
Loans from owners or related parties must reflect market terms or the IRS can impute interest or reclassify the transaction as equity. Section 7872 and transfer pricing rules can create taxable interest or reduce your deduction if the arrangement lacks commercial terms. Use a written loan agreement with a clear interest rate and repayment schedule.
PPP, SBA, and Forgiven Loans: What Happens to the Interest Deduction
Loans that are forgiven have had changing treatment in recent years. Current federal law allows the deduction of otherwise deductible expenses paid with forgiven PPP proceeds, and forgiven loan amounts are excluded from income. Tax rules can change, so confirm the current IRS guidance before claiming deductions related to forgiven funds.
Where to Report Interest and What Forms Matter
Sole proprietors report business interest on Schedule C under interest expense lines. Partnerships and S corporations show interest on Form 1065 or Form 1120 S and flow through deductions on Schedule K-1. C corporations report interest on Form 1120.
Large or complex filers use Form 8990 to compute the business interest limitation. Keep year-end statements and the loan amortization schedule to support figures.
Records to Keep and Audit Triggers
Keep the loan agreement, amortization schedule, bank deposits, and transfers that trace funds to business expenses, and invoices for items purchased with the loan proceeds.
Common audit triggers include commingled accounts, lack of documentation tying funds to business use, and related party loans without market terms. If you keep a clear, contemporaneous record,s you make tax prep and any audit review far easier.
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What Types of Loans Qualify?
SBA Loans
SBA guaranteed loans issued through banks and other lenders usually qualify for deductible interest when you use the proceeds for business purposes. Lenders provide the cash; the SBA backs a portion of the loan, and the IRS treats the interest like any other business interest when funds finance ordinary business activity.
Term Loans
Classic term loans used to buy inventory, hire staff, or expand operations generate deductible interest so long as you use the money for the business. Short-term and long-term loans follow the same basic rule: allocate interest to business use and keep records.
Business Lines of Credit
Interest on a revolving line of credit is deductible only on the portion you draw and use for business needs. Track withdrawals and match expenses to the period when interest accrued to support the deduction.
Refinancing Loans
If you refinance an existing business debt, the interest on the new loan is deductible if the refinanced funds continue to serve business purposes. If you use some proceeds to pay personal obligations, you must split the interest and only deduct the business portion.
Equipment Financing
Loans secured by machinery, vehicles, or computers typically produce deductible interest when the asset serves the trade or business. If you later use the equipment partly for personal reasons, allocate interest and depreciation between business and personal use.
Commercial Real Estate and Construction Loans
Interest on loans to buy or build commercial property typically qualifies for deduction, but interest incurred during construction may need special handling and can be capitalized into the asset cost. The rules require you to separate the interest that must be capitalized from the interest you can deduct now.
Business Credit Cards
Interest on balances that come from business purchases is deductible when the charges directly support the trade or business. High rates do not change deductibility, but personal charges on the card must be excluded.
Related Party and Shareholder Loans
Loans between the company and its owners or related entities receive extra scrutiny. The IRS looks at whether the instrument is actual debt or equity, and may impute interest if the rate is below market. Keep formal loan documents, market rate terms, and a clear repayment pattern to support interest deductions.
Mixed Use Loans and Allocation Rules
When a single loan funds both business and personal needs, you must allocate interest between deductible business use and nondeductible personal use. Document how you used proceeds and apply a reasonable allocation method.
Interest Capitalization and Construction Period Interest
Interest on funds used to construct or produce certain long-lived assets often must be capitalized and added to the asset’s basis rather than deducted immediately. Identify construction period interest early and follow capitalization rules so you do not claim an improper current deduction.
Limits, Exceptions, and the Business Interest Deduction Cap
A general limit can reduce the amount of business interest you deduct in a year. The code applies a cap tied to taxable income and business interest income, and there are exemptions for smaller firms that meet the gross receipts test. Certain real property businesses can elect special rules that change how interest is treated.
Documentation, Business Purpose, and Practical Steps
Keep written loan agreements, deposit and disbursement records, and unmistakable evidence that proceeds were paid to business expenses. Separate accounts and strict bookkeeping make it easy to match interest to business uses and survive audits. Ask whether funds went to ordinary and necessary business activity, then keep the paper trail.
How audits and related rules can affect your deduction
The IRS may reclassify poorly documented loans as capital contributions or deny interest for nonbusiness use. Below-market-related party loans can trigger imputed interest rules. Prepare contemporaneous documentation and validate that transactions reflect arm’s length terms.
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Exceptions and Grey Areas
If your company clears the gross receipts test, you face the interest limitation. The rule caps deductible business interest at 30 percent of adjusted taxable income plus business interest income and floor plan financing interest.
Gross receipts are measured over a multi-year lookback, and the statutory threshold adjusts for inflation; check which threshold applies to your tax year. Corporations and pass-throughs both run this calculation and file Form 8990 to document it. Do you track the three-year receipts test and the return forms that flow the numbers?
Adjusted Taxable Income Explained In Plain Terms
Adjusted taxable income starts with taxable income but strips out specific items for the 163(j) cap. Remove business interest expense, interest income, and the net operating loss deduction.
For recent years, depreciation and amortization generally do not get added back, although temporary rules in prior years occasionally changed that treatment. The math can swing wildly based on how you treat depreciation or a one-time gain. Who on your team owns the ATI build and the depreciation policy?
What Counts As Business Interest Income And Deductible Interest Expense
Business interest income includes interest on operating cash balances, customer financing, commercial loans, and some short-term investments. Deductible interest expense is the interest component of payments; principal repayments are not deductible.
Prepayment penalties usually count as interest. Payment in kind interest and accrued interest may be deductible on accrual basis returns when accrued, but cash method taxpayers deduct only when paid. Does your amortization schedule cleanly separate principal and interest?
Floor Plan Financing: A Dealer Carve Out Worth Watching
Floor plan financing interest, primarily used by motor vehicle and specific equipment dealers, sits outside the 30 percent cap when correctly identified. That treatment reduces the pressure on inventory-heavy sellers who finance goods for resale.
The IRS expects precise tracking so you can prove which interest came from floor plan lines and which did not. Is your accounting grouping floor plan loans separately and tagging their interest correctly?
Industry Elect Outs: Real Property And Farming Choices And Tradeoffs
Real property trades or businesses and farming businesses may elect out of the 30 percent limit. Electing requires meeting statutory tests and accepting tradeoffs. For real property, you usually must use alternative depreciation system rules for certain assets going forward, which slows depreciation and raises taxable income in many cases.
The election can be irrevocable for some periods and creates downstream reporting shifts. Have you modeled the long-term tax cost of electing out versus staying subject to the cap?
Carryforwards: What Happens To Disallowed Interest
Any business interest you cannot deduct because of the cap carries forward indefinitely until used. The brought forward amount preserves the character of business interest and reduces future taxable income when the limitation loosens because ATI rises or interest income changes.
You must track the origin year, the amount carried, and the interaction with future years’ ATI. Who will reconcile the carried interest and attach the required computation to next year’s return?
Practical Filing Steps And The Paperwork The IRS Will Want
Prepare Form 8990 and supporting schedules that show ATI, business interest income, floor plan interest, and the excess carried forward. Keep loan agreements, amortization schedules, bank statements, canceled checks, and any intercompany promissory notes.
For partnerships and S corporations, flow the partnership computations to partners and attach detailed statements to Schedule K-1. Auditors will ask for a clear trail from the loan document to the return entry. Does your file include a signed loan contract and a payment ledger tied to bank activity?
Common Gray Areas That Trigger Audits Or Disagreement
Debt versus equity classification remains a frequent flashpoint. Related party loans, below-market loans with imputed interest, and interest allocable to tax-exempt income create tricky adjustments. Capitalized interest on property placed in service must be separated from current deductible interest.
Consolidated groups face allocation rules that change the result from separate return calculations. Thin capitalization debates and disguised dividends can move a deduction into nondeductible territory. Which of these risks applies to your credit structure?
Tax Planning Maneuvers That Shift Outcomes Without Breaking Rules
You can manage interest deduction outcomes by timing interest payments, converting some debt to equity where economically sensible, using term changes to alter amortization, or evaluating the real property trade or business election.
Reclassifying loan fees correctly and deciding whether to capitalize or expense fees changes the ATI path. Any change must rest on sound legal and financial support because that support shows up in audits. Who will run scenario tests to show the tax and accounting impact before you change terms?
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How to Track and Claim the Deduction
Keep the loan agreement, promissory note, and the amortization schedule. Save lender statements and cancelled checks that match interest payments. Keep deposit records showing where loan proceeds went and invoices or receipts for the expenses paid with those funds.
If a lender issues a 1098 or a statement showing interest, keep that with your file. Create a one-page worksheet that ties each interest payment to the business expense it funded and the date paid.
Keep Business and Personal Money Separate
Open and use a business checking account and a business credit card for all company spending. When owners mix funds, add a written loan agreement, and record interest at a market rate so the IRS can see the transaction is real, how you pay vendors and payroll matters for tracing interest back to business use.
Allocate Interest When Loan Proceeds Were Used for Mixed Purposes
If proceeds are paid for both business and personal costs, compute a business use percentage. Apply that percentage to each interest payment and document the math with receipts.
For example, if 70 percent of funds went to equipment and 30 percent to a personal expense, claim 70 percent of the interest as business interest and keep the backup showing the split.
Cash Versus Accrual: When You Can Deduct Interest
Cash basis taxpayers generally deduct interest when they pay it. Accrual basis taxpayers deduct interest when it is incurred, even if not yet paid. Prepaid interest may need to be amortized over the period it covers. Which accounting method do you use this year?
Principal Versus Interest: Know What Is and Is Not Deductible
Principal repayments are not deductible. Interest is deductible when the rules permit. Interest that funded the purchase or construction of a capital asset often must be capitalized into the asset cost and recovered later through depreciation or cost of goods sold. Keep the purchase invoices and depreciation schedules to show how you recovered that cost.
Where to Report Interest on Your Tax Return
Sole proprietors report business interest on Schedule C of Form 1040. Partnerships report interest on Form 1065 and allocate the deduction to partners via Schedule K-1. S corporations and C corporations report interest on Form 1120 S and Form 1120, respectively. If your situation triggers the business interest limitation, prepare Form 8990 to compute the allowed deduction.
Watch the Business Interest Limitation Rules Under Section 163(j)
The deduction for business interest may be limited to business interest income plus 30 percent of adjusted taxable income for some taxpayers. Small businesses with average annual gross receipts under the statutory threshold may be exempt from that limit.
Disallowed interest typically carries forward to future years, where it may be deductible when the limit allows. Pull your three-year gross receipts and your adjusted taxable income numbers to see if the limit applies.
Related Party Loans and Market Terms
If you borrow from a shareholder, owner, or related party, use a written promissory note and charge a market rate of interest. The IRS scrutinizes related party transactions, so document how you set the rate. If you forgive interest or restructure the loan, record the transaction and tax treatment in your books.
Make Your File Audit Ready: Practical Checklist
Assemble the loan agreement, amortization schedule, lender statements, bank deposits showing proceeds, invoices for expenses paid, allocation worksheets for mixed uses, board minutes or resolutions if applicable, and the tax forms where interest was claimed.
Keep tax returns and the supporting schedules that show how you calculated the deduction for at least three years and up to seven years when possible. Do you want a printable checklist you can use straightaway?
When to Call a Professional
Complex rules apply to business interest limits, capitalization of interest for asset projects, related party loans, and accounting method changes. A qualified accountant or tax advisor can ensure you apply the rules correctly and capture any carryforwards or elections that preserve value for future years. Which part of this would you like help documenting?
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Book a Call to Learn More About our Accounting Services (Trusted by 400+ Startups)
Are the payments you make on a business loan tax-deductible? Short answer: only part of the payment usually counts. The IRS lets you deduct interest charged on business debt as a business expense.
The repayment of principal is not deductible because it simply returns borrowed capital. Which part is of interest depends on the loan agreement and your accounting method.
Principal Versus Interest: Know the Difference That Matters
When you make a loan payment, split the amount between principal and interest. Interest shows as an interest expense on your profit and loss statement. Principal reduces your loan liability on the balance sheet.
This split matters for taxable income, cash flow modeling, and federal reporting like Schedule C for single-owner businesses or Forms 1120, 1065, and 1120S for entities.
Interest Expense Rules: What Is Deductible and When
Deductible interest includes ordinary interest paid or accrued on loans used for business operations, equipment, and operating capital. Capitalized interest tied to a qualifying asset may need to be added to the asset basis and depreciated or amortized over time.
If you prepay interest, the timing of the deduction depends on cash or accrual accounting and specific IRS rules for prepaid interest.
Business Interest Limitation: How Section 163(j) Can Affect You
The business interest deduction may be limited under Section 163(j). Generally, corporate and many partnership owners can deduct business interest up to the sum of business interest income plus 30 percent of adjusted taxable income, with some exceptions.
Small businesses under the gross receipts test may be exempt. Check whether your business meets the threshold and whether you need to apply the limitation.
Loan Fees, Points, and Origination Costs: Expense or Amortize
Loan origination fees, points, and similar financing costs are often capitalized and amortized over the life of the loan. Some expenses that are insignificant or directly tied to short-term borrowing may be deductible immediately. How you treat these items affects taxable income, effective interest rate, and your monthly bookkeeping entries.
Special Loan Types: PPP, SBA, Equipment Loans, and Mortgages
Did you take a PPP loan, an SBA term loan, an equipment loan, or borrow to buy real estate? Forgiven PPP loans have unique tax treatment that changes annually and can affect whether you can deduct related expenses.
Equipment loans usually produce deductible interest and possible Section 179 or bonus depreciation for the asset. Mortgage interest on business property is generally deductible as a business interest expense.
Accrual Versus Cash Basis: Timing Your Interest Deductions
Your accounting method governs timing. Cash basis taxpayers often deduct interest when paid. Accrual basis taxpayers deduct interest when incurred, subject to capitalization rules and matching principles. Choose the method that fits your business size and operations, and keep consistent records to support deductions at audit.
Related Party Loans and Thin Capitalization Risks
Loans from owners or related entities receive extra scrutiny. The IRS looks at interest rates, repayment terms, and whether the loan behaves like equity. If a related party loan lacks proper documentation or reasonable interest, the IRS could reclassify payments or disallow interest deductions. Maintain fair market terms and contemporaneous documentation.
Recordkeeping and Reporting: What to Track and Where to Report
Track loan agreements, amortization schedules, bank statements, issued interest invoices, and any capitalized interest calculations. Report interest on the appropriate tax forms and schedules. Issue Form 1099 if required for certain interest payments to individuals or unincorporated vendors. Accurate records speed audits and improve credibility with lenders.
What This Means for Your Tax Planning: Questions to Ask Now
Ask these questions about any loan:
What portion of payments is interest?
Does 163(j) limit my deduction?
Are fees capitalized or deductible?
Will related party rules apply?
Your answers affect cash tax, quarterly estimated payments, and whether you should accelerate or defer interest payments.
How Haven Helps: Let Your Business Take Flight While We Manage the Runway
Haven handles daily bookkeeping, monthly close, complex tax filings, and R&D credits that put cash back in your pocket, plus fractional CFO services that align finance and strategy. Over 400 startups trust our CPAs for 24/7 Slack support, accurate filings, and aggressive but defensible tax positions that saved millions in credits and cut admin hours.
Want a CPA to review your loan interest treatment, Section 163(j) exposure, and potential R&D credit claims? Book a call today and connect with a dedicated team that manages filings and lets founders focus on growth.