Is a Home Equity Loan for Business Tax Deductible?

Using a home equity loan to fund a business can be appealing due to potentially lower interest rates than traditional business loans. However, whether the interest is tax deductible depends on how the funds are used and if they meet IRS requirements.

Qualifying Conditions for Deductibility

For home equity loan interest to be deductible for business, the IRS requires the funds to be directly tied to business operations. This includes expenses such as purchasing equipment, paying employees, or marketing. If any portion of the loan is used for personal expenses, only the business-related interest is deductible.

The loan must be secured by the taxpayer’s primary or secondary residence. The Tax Cuts and Jobs Act (TCJA) of 2017 restricted home equity loan interest deductions to cases where the funds are used to buy, build, or substantially improve the home securing the loan. However, business owners may still deduct interest if they allocate the loan to business expenses and claim it as a business interest deduction rather than a mortgage interest deduction.

To qualify, the loan must be properly traced to business use under IRS tracing rules. Taxpayers should maintain clear records showing how the loan proceeds were spent. If the funds are deposited into a business account and used exclusively for business expenses, the interest may be deductible under IRS rules, which limit business interest deductions to 30% of adjusted taxable income (ATI). Small businesses with average annual gross receipts under $29 million (for tax year 2024) are exempt from this limitation.

Proper Loan Structuring

How a home equity loan is structured affects tax treatment and financial flexibility. Keeping business and personal finances separate is crucial. Loan proceeds should be deposited directly into a business bank account to prevent commingling, which can complicate tax reporting and potentially disqualify interest deductions.

Loan terms should align with the business’s financial needs. If the loan funds inventory with a short turnover cycle, a shorter loan term may be preferable. For long-term assets like machinery, a longer repayment schedule can help preserve working capital. Business owners should also consider whether a fixed or variable interest rate is more suitable.

Legal structuring also matters. If the business is a sole proprietorship, the owner is personally liable for the loan. If structured as an LLC or corporation, documenting the loan as a capital contribution or shareholder loan can impact how the business records the liability and whether repayments are categorized as business expenses or owner distributions. A promissory note between the owner and the business can help substantiate the loan’s purpose in case of an IRS audit.

Calculating the Deduction

Determining the deductible portion of interest on a home equity loan used for business requires careful allocation. The IRS allows deductions only for the interest attributable to business use. If the entire loan is applied to business costs, the full interest amount may be deductible within the set limits. If a portion is used for personal expenses, only the business-related interest qualifies, requiring a proportional calculation.

For example, if a $100,000 home equity loan carries a 7% annual interest rate, the total interest for the year would be $7,000. If $60,000 is used for business expenses and $40,000 for personal use, only 60% ($4,200) of the interest can be deducted. This allocation must remain consistent unless additional funds are drawn specifically for business purposes.

The deduction is also subject to business income limitations. Under IRS rules, business interest deductions are generally capped at 30% of adjusted taxable income (ATI) unless the business qualifies for the small business exemption. If a company’s ATI is $50,000, the maximum deductible interest would be $15,000. Any excess must be carried forward to future tax years unless the business falls under the exemption threshold.

Documentation and Record-Keeping

Maintaining thorough records is essential. The IRS requires taxpayers to substantiate deductions with clear evidence, making well-organized documentation necessary in case of an audit. Retaining loan agreements, bank statements, and detailed expense records ensures that every dollar borrowed can be traced to its intended use.

Interest payments should be meticulously recorded, with supporting documents such as monthly loan statements and proof of payment. These records should align with financial statements and tax filings. Maintaining an amortization schedule that outlines principal and interest payments over time can help verify the deduction amount claimed each year. Taxpayers should also be prepared to provide supporting business records, such as invoices and receipts, that directly link expenses to the loan proceeds.

Effect on Overall Business Tax Liabilities

Using a home equity loan for business affects more than just interest deductions—it also impacts overall tax liabilities. How the loan is classified on financial statements and tax returns influences taxable income, debt ratios, and tax planning strategies. Properly structuring the loan and ensuring compliance with IRS regulations can help maximize deductions while avoiding unintended tax consequences.

Since interest on a home equity loan used for business is categorized as a business interest expense, it reduces taxable income. However, businesses operating at a loss or with minimal taxable income may not fully benefit from the deduction in the current year. In such cases, excess interest deductions may need to be carried forward until they can be utilized. Additionally, the loan increases the business’s liabilities, which can affect financial ratios used by lenders and investors. A higher debt-to-equity ratio may influence creditworthiness and borrowing capacity, potentially impacting future financing options.