Once a Real Estate Agent has determined that their business debt meets the IRS definition of a loan, as discussed in our article, Real Estate Agents: Deducting Business Interest Part One, IRS Loan Definition, and that the loan proceeds financed a business purpose (See Real Estate Agents: Deducting Business Interest Part Two, Business Purpose), answering next questions are relatively straightforward: Where and When do I deduct it? This article answers this question.
Where to Deduct Loan Interest
There are two lines on Schedule C for deducting loan interest: Line 16a Mortgage Interest, and Line 16b Other Interest. It’s important to deduct interest on the proper line to avoid an IRS inquiry.
Line 16a Mortgage Interest: Mortgages are loans secured by real property (land and buildings). Mortgage interest deducted on Line 16a includes interest paid on loans used for business, even if the firm does not own the securing property. For example, a Real Estate Agent uses the equity in her and her spouse’s home to purchase business equipment. Interest on the loan is deductible on Line 16a, even though her business does not own her home.
It is important to note, however, that when any debt, including a home equity loan, secures both personal and business debt, the owner must determine the amount of business interest paid. Separating business and personal interest is reasonably complex and discussed in Part Two of our interest series).
Do not deduct interest paid on a mortgage used to build, buy or improve a residence containing a qualified home office on Line 16a. Report this interest on Form 8829, Business Use of Your Home. For more information on deducting home office interest, please see our article, Deducting Actual Home Office Expenses.
Lenders are required to send borrowers Form 1098, Mortgage Interest Statement reporting annual interest (and any points) deductible on Line 16a. IRS computers match interest reported to business owners on Form 1098 to interest deducted on Line 16a of Schedule C. If the amounts are not the same, the taxpayer may receive an IRS notice requesting clarification. To avoid this scrutiny, only enter interest reported via Form 1098 to the business, the business owner, or their spouse (if filing jointly) on line 16a.
If you do not receive a Form 1098 for the mortgage interest paid, or if lender sends it to an individual with whom you own the property, report deductible business interest on Line 16b (other interest). You should also attach a statement to your return stating the name and address of the individual receiving the 1098 and write “See Attached” next to line 16b.
Also, attach a statement explaining why mortgage interest reported on Line 16a does not match the total conveyed to you on Form(s) 1098.
Line 16b Other Interest: Deduct non-mortgage interest and mortgage interest not reported on Form 1098 on Line 16b, Other Interest. Deductible interest includes but is not limited to:
- Personal Loans Used for Business
- Business Lines of Credit
- Credit Card Interest (business portion)
- Business Loans from Family and Friends (provided they meet the IRS Loan Definition)
- Interest included in lease-to-own purchases
- Mortgage interest for which a Form 1098 is not received
- Your business portion of Mortgage interest reported to a non-spouse on Form 1098, or a spouse is filing your tax return separately.
- Interest paid on late-paid employment taxes (but not interest on any penalties, fines, income tax, or any violation of the law)
- Prepayment penalties on loans and mortgages are considered interest and deductible on Line 16b (if not reported on Form 1098)
- Interest on auto loans (based on business use)
- Other interest meeting the IRS Loan Definition and the Business Purpose Test.
When to Deduct Business Interest
When a business deducts interest depends on its accounting method. An accounting method determines when a company records (recognizes) income and expenses. There are two basic accounting methods, albeit variations occur in many industries: the cash-basis accounting method, and the accrual-basis accounting method.
Cash-Basis Taxpayer: The vast, vast majority of Real Estate Agents are cash-basis taxpayers, as are most small business owners who file Schedule C. Cash-basis businesses count income when received and expenses when paid. For cash-basis taxpayers, deduct interest as an expense in the year paid to the lender.
Accrual-Basis Taxpayer: Accrual-basis accounting is more complicated than cash-basis accounting. Accrual basis businesses count income when they earn it and expenses when they incur them.
Accrual accounting can be confusing. It is one of the more difficult topics for accounting students to master. Using a basic example to compare and contrast accrual and cash-basis accounting methods may help clarify the concepts.
An accountant who uses the accrual method of accounting prepares a tax return and sends her client an invoice. Under accrual accounting, sending the invoice is the event showing that she has earned the income from the tax return. When the invoice is created, she records the tax return as income. Alternatively, if she were a cash-basis taxpayer, she would not recognize the revenue until she receives payment from her client.
Now, let’s say the same accrual-basis accountant receives her office electric bill. Her accrual policy is to record electricity as an expense when she can determine the cost incurred - when she receives her electric bill. If, on the other hand, she were a cash-basis taxpayer, she would not record her electricity expense until she pays the invoice.
If this seems confusing, don’t worry. It is! Fortunately, cash-basis accounting is much simpler, and the monthly and annual statements sent by most lenders report the amount of cash-basis interest paid.
Take Away: This article closes out our series on deducting interest on Schedule C. As discussed in our Deducting Interest Expense Part One: Meeting the Loan Definition and Deducting Interest Expense, Part Two: Business Use of Proceeds the vast majority of interest generated by traditional financing is reasonably straightforward. Some loans, however, can seriously complicate and jeopardize a Real Estate Agent’s interest deduction. To ensure your loan interest is deductible, heed the warnings of these articles. Make sure borrowed funds meet the IRS definition of a loan, use the funds for a business purpose, and don’t mix business and personal-use debt. Finally, as stated in this article, deduct interest on the correct line to avoid IRS scrutiny.
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