Is Interest Expense Tax Deductible for a Business?

Businesses often rely on borrowed money to fund operations, expand, or manage cash flow. Interest payments can be significant, making it important to understand whether these expenses can reduce taxable income.

Tax laws allow businesses to deduct certain types of interest expenses, but not all interest qualifies. Various rules and limitations apply, depending on the nature of the debt and how the funds are used.

Types of Business Interest

The way a business borrows money determines the type of interest expense it incurs. Understanding these borrowing methods helps assess their financial impact and tax treatment.

Loans

A business loan involves borrowing a fixed amount from a lender and repaying it over time with interest. Loans can be secured, requiring collateral like equipment or property, or unsecured, which typically have higher interest rates due to increased risk for the lender. Interest rates vary based on creditworthiness, loan term, and market conditions.

For example, a company taking out a $500,000 loan at an annual interest rate of 6% would pay $30,000 in interest over a year. Some loans have variable rates, meaning payments fluctuate with market conditions. Businesses often use these funds for major investments, such as purchasing machinery or expanding operations. Loan agreements outline repayment schedules, fees, and total interest costs.

Credit Lines

A business line of credit provides flexible access to funds, allowing companies to borrow as needed up to a set limit. Interest is only paid on the amount drawn, making it useful for managing short-term cash flow or covering unexpected expenses.

For instance, if a company has a $100,000 credit line with an 8% annual interest rate and withdraws $40,000, interest accrues only on that portion. If the balance is repaid within a month, the cost is minimal, but carrying a balance over time increases expenses. Some credit lines also have maintenance fees or usage restrictions. Businesses often use them to bridge revenue gaps or fund seasonal inventory purchases.

Mortgages

Commercial real estate purchases often involve a mortgage, a long-term loan secured by property. These loans typically have fixed or adjustable interest rates and repayment terms ranging from 10 to 30 years. Interest expenses can be substantial, particularly in the early years when payments primarily cover interest rather than principal.

For example, a business purchasing a warehouse for $1 million with a 20-year mortgage at 5% interest would initially pay around $50,000 annually in interest, excluding principal payments. Some mortgages include balloon payments, requiring a lump sum at the end of the term. Businesses use real estate loans to acquire office space, retail locations, or manufacturing facilities, affecting both cash flow and long-term financial planning.

Key Tax Deductibility Standards

For interest expenses to be deductible, they must be ordinary and necessary, meaning they are common in the industry and directly related to business operations. The debt must also be legitimate, with a clear obligation to repay. Loans between related entities designed solely to generate deductions may be disallowed under anti-avoidance rules.

The 2017 Tax Cuts and Jobs Act (TCJA) introduced limitations on business interest deductions under Section 163(j). Most businesses cannot deduct interest expenses exceeding 30% of adjusted taxable income (ATI), which is taxable income before interest, depreciation, and amortization. However, businesses with average annual gross receipts below $29 million (as of 2024) are exempt. Certain industries, such as real estate and farming, can elect out but must use longer depreciation schedules for assets.

Interest on debt used for passive activities—such as investments without material participation—is generally not deductible against active business income. If a business borrows to acquire an ownership stake in another company, the interest may only be deductible if the investment generates taxable income. Capitalized interest, which is added to the cost of long-term assets instead of being expensed immediately, must be amortized over time rather than deducted in the year incurred.

Recordkeeping for Tax Filing

Maintaining accurate records is necessary to substantiate interest expense deductions and comply with IRS regulations. Proper documentation supports tax filings and prepares businesses for potential audits. Without sufficient records, deductions can be denied, leading to higher tax liabilities and possible penalties.

Businesses should retain loan agreements, bank statements, and amortization schedules to verify debt obligations. Interest payments must be clearly identifiable in financial records, with supporting documents such as canceled checks, electronic payment confirmations, and lender-issued annual interest statements (Form 1098 for mortgage interest). Keeping separate records for multiple loans ensures that only qualifying expenses are deducted.

Beyond documentation, businesses should reconcile interest expenses with financial statements and tax filings. The IRS often scrutinizes deductions that appear excessive relative to revenue, making it important to ensure reported interest aligns with business activity. Proper classification of interest payments—whether as an operating expense, capitalized cost, or related-party transaction—affects tax treatment and financial reporting accuracy.

Accounting for Refinanced Debt

When a business refinances debt, the accounting treatment depends on whether the refinancing results in a modification or an extinguishment of the original liability. Under U.S. Generally Accepted Accounting Principles (GAAP), a debt modification occurs when the new terms are not substantially different from the original obligation, meaning the present value of cash flows does not change by more than 10%. In this case, the existing liability remains, and any fees or costs incurred adjust the carrying value of the debt and are amortized over the remaining term.

If the refinancing qualifies as an extinguishment, the original debt is removed from the balance sheet, and the new liability is recorded at fair value. Any unamortized fees or issuance costs from the original debt must be written off immediately, impacting net income. The difference between the carrying amount of the old debt and the amount paid to settle it is recognized as a gain or loss. This treatment aligns with Accounting Standards Codification (ASC) 470-50, which governs debt modifications and extinguishments.

Distinctions Between Personal and Business Interest

Not all interest expenses qualify for tax deductions. The IRS only allows deductions for interest directly tied to business activities, meaning personal borrowing, even if used by a business owner, is generally not deductible. This distinction is especially important for sole proprietors and small business owners who may use personal credit cards or loans for business expenses.

If a loan is taken out in an individual’s name but used for business purposes, the deductibility depends on how the funds are applied. For example, if a business owner takes out a personal loan and uses 70% for business expenses and 30% for personal use, only the business portion of the interest is deductible. Proper documentation is necessary to substantiate this allocation. Business owners who commingle personal and business finances risk losing tax benefits and may face increased scrutiny during audits.

Interest on business credit cards or loans taken out in the company’s name is generally deductible, provided the funds are used for operational expenses, asset purchases, or other legitimate business needs. However, if a business owner uses a company credit card for personal expenses, the interest on those charges is not deductible. Partnerships and corporations face stricter separation requirements, as personal expenses charged to a business entity can be classified as distributions or compensation, which may have additional tax consequences. Proper financial management and clear separation of personal and business finances help ensure compliance with tax regulations while maximizing allowable deductions.