As a concept, interest is pretty simple. It is money paid for the right to use someone else’s money. In other words, a loan. Loans can take many forms: secured and unsecured mortgages, lines of credit, auto financing, credit cards, pay-day lending, and amounts borrowed from friends and family. The rate of interest paid on these loans can vary greatly depending on several factors including the amount borrowed, the length of the pay-back period, the existence of collateral, and the creditworthiness of the borrower. But, when is the interest paid on loans deductible on Line 16 of Schedule C, Profit and Loss from Business? Answering this question will be the focus of this article-series and is drawn from our Real Estate Agent: Tax Cut Library.
Before we drill down on the specifics of the interest deduction, however, we need to discuss two import factors that make business interest deductible. First: The money owed to the other party must meet the IRS definition of a loan – the topic of this article. Second: The borrowed funds must serve a legitimate business purpose. For more information on this topic, please check out our article on the business use of loan proceeds.
The IRS Definition of a Loan
To be deductible, borrowed funds must meet the IRS definition of a loan. This definition has three criteria: 1) Legal liability, 2) Repayment Intention, and 3) The existence of a genuine debtor/creditor relationship. Like many aspects of the tax code, these requirements can be somewhat subjective. Loans, such as those owed to a bank or other lending institution, have no trouble meeting all three parts of the loan definition. Other debts, such as those owed to your loving grandmother, may not be as convincing to an IRS auditor. Since it is the taxpayer’s responsibility to substantiate all deductions taken on their tax return, let’s take a look at each part of the IRS loan definition:
Legal Liability: Payment on the debt must be legally enforceable in court. If not repaid, the lender should have no problem obtaining a judgment against the borrower in court.
Intention to Repay the Debt: The borrower must have a genuine commitment to repaying the loan, and the lender should fully expect its repayment. The borrower should also make regular payments on the debt. When the borrower fails to make a payment, the lender is expected to take steps to retrieve it.
Debtor-Creditor Relationship: The parties involved in the transaction should have a bonified business association. There should be proof of the debt, preferably in the form of a written document. The interest rate charged should reflect the risk taken by the lender.
Loans obtained from banks and other creditors in the business of lending will have no problem meeting all of the requirements listed. The only time the IRS questions the legitimacy of an interest deduction, other than the business use of loan-proceeds, is when the recipient of the interest is an informal lender. The frequent denial of the interest deduction on loans owed to family, friends, and business associates exemplifies the need for adequate documentation and proper treatment of such debts. To ensure an obligation meets the IRS loan definition, make sure it includes the following elements:
- A legally binding agreement that governs the terms of the loan.
- The agreement should state the amount of the loan, its interest rate, terms of repayment as well as the consequences of late and nonpayment.
- Business-like treatment of the loan by the borrower and lender, including regular payments, calculation of interest, and the lender’s pursuit of missed payments.
- The loan must include interest. If it does not, the IRS will require its calculation based on a published rate.
- If the borrower deducts the interest they pay as an expense, the lender should report the same amount as income on their tax return.
Lacking any one of these items will not automatically terminate the obligation’s status as a loan. The essential element is the business-like treatment of the borrowed funds. The other factors reinforce this treatment.
Example of What NOT to Do: Here’s a typical example of a “loan” that fails the IRS loan definition. Jill borrows $10,000 from her uncle for her business. There is no written promissory note, but they verbally agree that Jill will pay the loan back over two years at an interest rate of 4% annually. Jill accepts the money and buys business equipment with it. Like many startups, Jill’s business struggles for the first year, and she has no money to make payments on the loan. Cashflow improves the following year, but Jill still makes no payments on the loan. She forgets about the terms of the agreement and thinks her uncle is not concerned about it because he has not mentioned it.
Two years later, a year after full payment was due, at Thanksgiving Dinner (BTW – family loans can ruin holidays), her uncle finally asks her where his money is. His question – made in front of Jill’s parents, brothers, and sisters – profoundly embarrasses Jill. Prodded to save face, she makes her uncle a partial payment of $2,500 the following week.
The next spring, Jill deducts accrued interest included in the $2,500 payment on her business’s tax return. Six months later, the IRS reviews her tax return and denies the deduction because the debt fails to meet the IRS definition of a loan.
Consequences of Failing IRS Loan Definition: When borrowed funds do not meet the IRS definition of a loan, there can be several, often unintended consequences.
- As per the example above, interest is not deductible.
- The IRS will often reclassify unsubstantiated loans as gifts, which may have Gift Tax consequences.
- If the borrower does not repay the borrowed money, the lender will not be able to deduct the loan as a bad debt on his or her tax return.
- Although this consequence will not impact sole proprietor Real Estate Agents, failing to have legitimate loans can have severe consequences to those who own entities such as S Corporations who lend money to or borrow money from their company. Funds that fail the IRS definition could result in the entity’s termination as an S Corporation, among other things.
Take Away: To deduct loan interest, the borrowed funds must meet the IRS definition of a loan. It must be: 1) A legally enforceable loan, 2) that the borrower is intent on paying, and the lender is intent on collecting, between 3) parties that have a bonified debtor-creditor relationship. Interest on loans that do not meet this definition is not deductible on the borrower’s tax return. Debts that most commonly fail to meet the IRS loan definition are informal funds borrowed from friends, relatives, and business associates. An additional requirement is that loan proceeds be used for a business purpose, as discussed in our next article on deducting business interest.
Summary and Invite: We hope this article helped you to understand the IRS definition of a loan as it pertains to deducting interest on Line 16 of Form Schedule C. If you’d like to learn more about cutting your most significant expense, TAXES, check out our Real Estate Agent Tax Cut Library. The Real Estate Agent Tax Cut Library includes over eight hours of video broken into twenty-nine searchable volumes and covers every possible deduction a Real Estate Agent can take on their tax return. Our Broker Version will help your entire agency cut their taxes! We also invite you to browse our courses.