This chapter discusses the tax treatment of business interest expense. Business interest expense is an amount charged for the use of money you borrowed for business activities. taxmap/pubs/p535-012.htm#TXMP14e914d1
You may want to see:
Publication 537 Installment Sales 550 Investment Income and Expenses 936 Home Mortgage Interest Deduction Form (and Instructions) Sch A (Form 1040): Itemized Deductions Sch E (Form 1040): Supplemental Income and Loss Sch K-1 (Form 1065): Partner's Share of Income, Deductions, Credits, etc. Sch K-1 (Form 1120S): Shareholder's Share of Income, Deductions, Credits, etc. 1098: Mortgage Interest Statement 3115: Application for Change in Accounting Method 4952: Investment Interest Expense Deduction 8582: Passive Activity Loss Limitations
See chapter 12 for information about getting publications and forms.taxmap/pubs/p535-012.htm#en_us_publink1000153572
The rules for deducting interest vary, depending on whether the loan proceeds are used for business, personal, or investment activities. If you use the proceeds of a loan for more than one type of expense, you must make an allocation to determine the interest for each use of the loan's proceeds.
Allocate your interest expense to the following categories.
- Nonpassive trade or business activity interest
- Passive trade or business activity interest
- Investment interest
- Portfolio interest
- Personal interest
In general, you allocate interest on a loan the same way you allocate the loan proceeds. You allocate loan proceeds by tracing disbursements to specific uses.
The easiest way to trace disbursements to specific uses is to keep the proceeds of a particular loan separate from any other funds.
The allocation of loan proceeds and the related interest is not generally affected by the use of property that secures the loan. taxmap/pubs/p535-012.htm#en_us_publink1000153575
You secure a loan with property used in your business. You use the loan proceeds to buy an automobile for personal use. You must allocate interest expense on the loan to personal use (purchase of the automobile) even though the loan is secured by business property.
If the property that secures the loan is your home, you generally do not allocate the loan proceeds or the related interest. The interest is usually deductible as qualified home mortgage interest, regardless of how the loan proceeds are used. For more information, see Publication 936.
The period for which a loan is allocated to a particular use begins on the date the proceeds are used and ends on the earlier of the following dates.
- The date the loan is repaid.
- The date the loan is reallocated to another use.
Even if the lender disburses the loan proceeds to a third party, the allocation of the loan is still based on your use of the funds. This applies whether you pay for property, services, or anything else by incurring a loan, or you take property subject to a debt. taxmap/pubs/p535-012.htm#en_us_publink1000153579
Treat loan proceeds deposited in an account as property held for investment. It does not matter whether the account pays interest. Any interest you pay on the loan is investment interest expense. If you withdraw the proceeds of the loan, you must reallocate the loan based on the use of the funds. taxmap/pubs/p535-012.htm#en_us_publink1000153580
Connie, a calendar-year taxpayer, borrows $100,000 on January 4 and immediately uses the proceeds to open a checking account. No other amounts are deposited in the account during the year and no part of the loan principal is repaid during the year. On April 2, Connie uses $20,000 from the checking account for a passive activity expenditure. On September 4, Connie uses an additional $40,000 from the account for personal purposes.
Under the interest allocation rules, the entire $100,000 loan is treated as property held for investment for the period from January 4 through April 1. From April 2 through September 3, Connie must treat $20,000 of the loan as used in the passive activity and $80,000 of the loan as property held for investment. From September 4 through December 31, she must treat $40,000 of the loan as used for personal purposes, $20,000 as used in the passive activity, and $40,000 as property held for investment.taxmap/pubs/p535-012.htm#en_us_publink1000153581
Generally, you treat loan proceeds deposited in an account as used (spent) before either of the following amounts.
- Any unborrowed amounts held in the same account.
- Any amounts deposited after these loan proceeds.
On January 9, Edith opened a checking account, depositing $500 of the proceeds of Loan A and $1,000 of unborrowed funds. The following table shows the transactions in her account during the tax year.
|January 9||$500 proceeds of Loan A and $1,000 unborrowed funds deposited|
|January 14||$500 proceeds of Loan B |
|February 19||$800 used for personal purposes|
|February 27||$700 used for passive activity|
|June 19||$1,000 proceeds of Loan C |
|November 20||$800 used for an investment|
|December 18||$600 used for personal purposes|
Edith treats the $800 used for personal purposes as made from the $500 proceeds of Loan A and $300 of the proceeds of Loan B. She treats the $700 used for a passive activity as made from the remaining $200 proceeds of Loan B and $500 of unborrowed funds. She treats the $800 used for an investment as made entirely from the proceeds of Loan C. She treats the $600 used for personal purposes as made from the remaining $200 proceeds of Loan C and $400 of unborrowed funds.
For the periods during which loan proceeds are held in the account, Edith treats them as property held for investment. taxmap/pubs/p535-012.htm#en_us_publink1000153583
Generally, you treat a payment from a checking or similar account as made at the time the check is written if you mail or deliver it to the payee within a reasonable period after you write it. You can treat checks written on the same day as written in any order. taxmap/pubs/p535-012.htm#en_us_publink1000153584
If you receive loan proceeds in cash or if the loan proceeds are deposited in an account, you can treat any payment (up to the amount of the proceeds) made from any account you own, or from cash, as made from those proceeds. This applies to any payment made within 30 days before or after the proceeds are received in cash or deposited in your account.
If the loan proceeds are deposited in an account, you can apply this rule even if the rules stated earlier under Order of funds spent would otherwise require you to treat the proceeds as used for other purposes. If you apply this rule to any payments, disregard those payments (and the proceeds from which they are made) when applying the rules stated under Order of funds spent.
If you received the loan proceeds in cash, you can treat the payment as made on the date you received the cash instead of the date you actually made the payment. taxmap/pubs/p535-012.htm#en_us_publink1000153585
Frank gets a loan of $1,000 on August 4 and receives the proceeds in cash. Frank deposits $1,500 in an account on August 18 and on August 28 writes a check on the account for a passive activity expense. Also, Frank deposits his paycheck, deposits other loan proceeds, and pays his bills during the same period. Regardless of these other transactions, Frank can treat $1,000 of the deposit he made on August 18 as being paid on August 4 from the loan proceeds. In addition, Frank can treat the passive activity expense he paid on August 28 as made from the $1,000 loan proceeds treated as deposited in the account. taxmap/pubs/p535-012.htm#en_us_publink1000153586
You can use the following method to determine the date loan proceeds are reallocated to another use. You can treat all payments from loan proceeds in the account during any month as taking place on the later of the following dates.
- The first day of that month.
- The date the loan proceeds are deposited in the account.
However, you can use this optional method only if you treat all payments from the account during the same calendar month in the same way.
If you have an account that contains only loan proceeds and interest earned on the account, you can treat any payment from that account as being made first from the interest. When the interest earned is used up, any remaining payments are from loan proceeds. taxmap/pubs/p535-012.htm#en_us_publink1000153588
You borrowed $20,000 and used the proceeds of this loan to open a new savings account. When the account had earned interest of $867, you withdrew $20,000 for personal purposes. You can treat the withdrawal as coming first from the interest earned on the account, $867, and then from the loan proceeds, $19,133 ($20,000 − $867). All the interest charged on the loan from the time it was deposited in the account until the time of the withdrawal is investment interest expense. The interest charged on the part of the proceeds used for personal purposes ($19,133) from the time you withdrew it until you either repay it or reallocate it to another use is personal interest expense. The interest charged on the loan proceeds you left in the account ($867) continues to be investment interest expense until you either repay it or reallocate it to another use.taxmap/pubs/p535-012.htm#en_us_publink1000153589
When you repay any part of a loan allocated to more than one use, treat it as being repaid in the following order.
- Personal use.
- Investments and passive activities (other than those included in (3)).
- Passive activities in connection with a rental real estate activity in which you actively participate.
- Former passive activities.
- Trade or business use and expenses for certain low-income housing projects.
The following rules apply if you have a line of credit or similar arrangement.
- Treat all borrowed funds on which interest accrues at the same fixed or variable rate as a single loan.
- Treat borrowed funds or parts of borrowed funds on which interest accrues at different fixed or variable rates as different loans. Treat these loans as repaid in the order shown on the loan agreement.
Allocate the replacement loan to the same uses to which the repaid loan was allocated. Make the allocation only to the extent you use the proceeds of the new loan to repay any part of the original loan. taxmap/pubs/p535-012.htm#en_us_publink1000153592
A debt-financed distribution occurs when a partnership or S corporation borrows funds and allocates those funds to distributions made to partners or shareholders. The manner in which you report the interest expense associated with the distributed debt proceeds depends on your use of those proceeds.taxmap/pubs/p535-012.htm#en_us_publink1000153593
If the proceeds were used in a nonpassive trade or business activity, report the interest on Schedule E (Form 1040), line 28; enter "interest expense" and the name of the partnership or S corporation in column (a) and the amount in column (h). If the proceeds were used in a passive activity, follow the Instructions for Form 8582, Passive Activity Loss Limitations, to determine the amount of interest expense that can be reported on Schedule E (Form 1040), line 28; enter "interest expense" and the name of the partnership in column (a) and the amount in column (f). If the proceeds were used in an investment activity, enter the interest on Form 4952. If the proceeds are used for personal purposes, the interest is generally not deductible.