Interest must meet two criteria to deduct it on a business tax return. First, the underlying loan must meet the IRS loan definition (discussed in our article, Real Estate Agents Deducting Business Interest Part One, IRS Loan Definition). Second, the borrower must use the loan for a legitimate business purpose. This requirement may seem straight forward, and it often is. For many self-employed, small business owners such as Real Estate Agents, however, proving this business-purpose can be a daunting, even impossible, task. This article will help agents understand the business-purpose requirement while pointing out a common pitfall that threatens their interest deduction.
Loans Must Have a Business-purpose
The nature of real estate sales does not lend itself to significant capital investments – one does not need a lot of expensive tools and equipment to be a real estate agent. As a result, most agents do not carry an extraordinary amount of business debt. Regardless of an agent’s debt-load, however, borrowed funds must finance the agent’s sales business to deduct the interest paid on them.
To help agents determine which debts qualify for a business interest deduction, let’s review some qualifying business-purpose debts and some that do not qualify.
Business-Purpose Debts are loans used to buy business assets or pay business expenses.
- Business Assets, including cameras, signs, office furniture, computer equipment, tablet, cell phone, business auto, and other business items.
- Business Real Estate such as a sales office owned by the business or the agent. If your business operates as a Limited Liability Company, the LCC may need to own the office to deduct mortgage interest on Schedule C. Note: Business real estate does not include a home office or a separate building located on the same parcel as your primary residence. Report interest on these mortgages as a direct or indirect expense on Form 8829, Expenses for Business Use of Your Home.
- Operating Expenses such as MLS fees, advertising, office supplies, E&O insurance, office rent, training, and any other ordinary or necessary business expense.
- Interest on Unpaid Payroll Taxes. This deduction does not extend to interest on other unpaid taxes such as income or self-employment tax. Nor does it apply to any government-imposed fine, penalty, including parking and speeding tickets.
- Prepayment Penalties on business mortgages and loans are considered loan interest.
- Debt on Mixed-Use Items. Some items, such as automobiles, often serve both a business and personal purpose. Interest on such loans is deducted based on the percentage of the asset’s use that is business-related. For instance, if 80% of the miles put on a mixed-use vehicle during the year are business-related, the business can deduct 80% of interest paid on the auto loan during the year. For more information on deducting auto expenses, check out our series of articles on the topic, starting with Auto Deduction Options & The Standard Mileage Rate.
NOT Business-Purpose Debt: Some forms of interest may seem like business debt, but are not deductible. Other types of interest may be deducted elsewhere on the agent’s tax return. Here’s a quick rundown:
- Loans for Personal Expenses. The non-deductibility of interest on personal loans may seem obvious, but it’s not always that straight forward. For instance, many agents are surprised to learn that interest on funds borrowed to pay personal bills during sales slumps or when they start their business is not business-related.
- Debt for Exam Training and Real Estate Exam. Becoming a licensed Real Estate Agent qualifies an individual for a new profession. Education and exam fees related to starting a new career are not deductible. As a result, interest paid on debt used to become a licensed real estate agent is not deductible. For more information on training and exam fees, please read our article, Real Estate Agents, Are License Training and Exam Fees Deductible.
- Mortgages on Investment and Rental Properties: If you hold vacant land as an investment, it is not directly related to your business as a Real Estate Agent. Interest on the loan may be deductible as investment interest on Form 4952 and Schedule A as an itemized deduction. Alternatively, the owner may have the option of capitalizing (adding to the basis – investment/cost – of the property) interest and property taxes paid on vacant land instead of deducting them. Deduct mortgage interest paid on rental properties on Part One of Schedule E, Supplemental Income and Loss. An exception to this rule would be an agent’s qualifying as a real estate professional, but this is rather rare, potentially tax-dangerous, and beyond the scope of this article. For more information on qualifying as a Real Estate Professional, Check out Toni Nitti’s Article in The Tax Advisor.
- Penalties & Interest: Fines and penalties paid to a government body for a violation of the law are not deductible. Nor is interest paid on such fines and penalties. Penalties and interest charged by non-government entities during the ordinary course of business, however, are allowed as a deduction. For example, you make a late payment on a leased copier, and the vendor charges your company a $25 penalty plus $2 in interest. The $25 is deductible as rent. The $2 of interest would be a deductible interest expense on Line 16(b).
The Major Pitfall to Avoid: Commingling Debt
Troublesome Commingling: The most common trap jeopardizing an agent’s interest deduction (and drives tax professionals bonkers!) is mixing business debt and non-business debt. When such mingling is not too extensive (for example, a $10,000 loan from a local bank when $2,000 is used to purchase business equipment and the remaining $8,000 is used to buy a used bass boat) calculating business interest is possible, but special rules apply.
Under IRS repayment ordering rules, the personal portion of mixed-use loans gets repaid before the business portion. The ordering rules require the layered amortization of the personal and business parts of the loan. Continuing with the example above, if the $10,000 is a five-year loan at 5% interest, the payment is $188.71. Since $2,000 is the business portion of the debt, it will accrue the same amount of interest each month until the personal portion is repaid. Here’s an illustration of how payments are applied and interest is calculated for first few months of the loan:
Payments first reduce personal principal. Deductible business interest remains the same each month until paying off the personal balance. Then, apply payments to the business portion.
Ridiculous Commingling: Taking out a single, mixed-use loan can prove error-prone and costly. Many agents who calculate such a loan’s interest deduction will do so incorrectly. Professional preparers must allocate payments and interest year-after-year, which takes additional time and may make completing the return more expensive.
The worst form or use-commingling, and, unfortunately, the most common, occurs when a business uses a revolving line of credit (IE – a credit card) to purchase both personal and business items. Regularly charging personal and business expenses to a credit card or credit line makes tracking deductible interest nearly impossible. It also makes any interest deduction taken extremely difficult to substantiate upon audit.
The saddest part credit card commingling is that the high-interest rate paid can make the deduction extremely valuable. Fortunately, reclaiming the tax-savings of this deduction is possible, at least for future years.
Avoiding the Commingling Pitfall: The easiest way to avoid losing an interest deduction to mixing personal and business debt is simple: DON’T DO IT! If your business needs financing, take out a loan and use it only for business. If you want to use a credit card for your business, pick one credit card, and use it ONLY for business. Doing so will save your interest deduction and simplify recordkeeping.
Notes on the Interest Deduction
As you may realize, something as seemingly-simple as deducting business interest can be quite complicated. The key to making this deduction easy to calculate and substantiate is to: 1) Have a straight-line between the loan and business purchase, and 2) Avoid commingling personal and business debt.
Although this is the moral of this article, there are a few more interest-related items to discuss before we close.
Home Office Interest: Report mortgage interest for a home that includes a home office on Form 8829, Expenses for Business Use of Your Home. The same with loans used to improve the home office. For more information, check out our article on deducting actual home office expenses or our course, Real Estate Agents Auto and Home Office Deduction.
Auto Loan Interest: As mentioned earlier, deductible interest on a business-use auto is based on the percentage of annual miles that are business miles. For more information, please read our articles on deducting auto expenses, starting with Auto Deduction Options, The Standard Mileage Rate, or take our course Real Estate Agents Auto and Home Office Deduction.
Unused Loan Proceeds: If a business goes into debt but does not immediately use the funds (for example, the loaned money is sitting in a bank account), interest paid on the funds are not deductible. Why? The loan does not yet have a business purpose. Interest paid on unused funds is considered investment interest, not a business expense. Investment interest is reported on Form 4952, and as an itemized deduction on Schedule A. Once the funds are spent on business, interest is deductible on Schedule C.
Loan Source Does Not Matter: The source of a loan is not taken into account when deducting interest paid. What matters is the business use (and being able to prove that use) of the borrowed funds. The loan can be a bank loan made to the owner, a home equity line of credit, the owner’s credit card, or a loan from a friend or relative (make sure these informal loans meet the IRS loan definition).
Take Away: Borrowed funds must have a legitimate business-purpose to deduct loan interest. Although business purpose seems straight-forward, the IRS routinely disallows interest deductions for lacking it. To ensure full deduction of interest on Schedule C, take steps to prove the business use of loan proceeds and, above all, avoid mixing business and personal debt on the same loan. Be especially wary of revolving lines of credit and credit cards.
Summary and Invite: We hope this article helps Real Estate Agents understand the importance of loans having a business-purpose when deducting interest. 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.