Borrowing Money for Your Business

If you are a small business owner looking for capital to start a business or expand an existing one, you will quickly learn that most lenders will require you to be personally liable on a secured loan.

A favorite source of funds for a small business owner looking for capital to start a business or expand an existing one is a loan on their home. Home loans usually provide a lower interest rate and are far easier to obtain than a business loan, which almost always will require a business owner to sign a personal guarantee and provide adequate security.

If planned carefully, using a home loan for business can provide a quick source of capital. However, if not thought out correctly, it can lead to unexpected tax results due to the complexity of the home mortgage interest rules. There are four tax rules that cause the complication and must be taken into consideration when considering your financing options:

1. Interest from loans secured by a taxpayer’s home (or second home) must be deducted as home mortgage interest to the extent the loans do not exceed specific debt limits for home mortgages, which are $1 million for acquisition debt and up to $100,000 of equity debt. Thus, a taxpayer cannot arbitrarily allocate a portion of the home mortgage interest to another use such as the taxpayer’s business.

2. The interest on loans secured by the home in excess of the sum of the acquisition debt and the equity debt can be traced to the use of the funds using the general tracing rules. Thus, the interest in “excess” of that allowed to be deducted as home mortgage interest can be traced to the actual use of the money (for example, the taxpayer’s business).

3. A taxpayer can make a tax election to treat any debt on the taxpayer’s home “as not secured by the home”. This election cannot be reversed without the IRS’s consent but can be eliminated by terminating the loan. This election is dangerous in that once it is made none of the interest can be deducted as home mortgage interest. Although you will now be able to trace (allocate) the portion related to your business, any part of the loan that is attributable to the home is no longer deductible. Thus, this election generally works best when used for second loans or lines of credit that are used 100% for business use.

4. Equity debt interest secured by the home or second home is not deductible for alternative minimum tax purposes. Thus, a taxpayer receives no tax benefit for interest paid on an equity debt to the extent the taxpayer is subject to the AMT. Business interest, on the other hand, is deductible for AMT purposes.

So why do you care where the interest is deducted? First and foremost, when interest is deducted as a business expense, it offsets your business income for both regular tax and self-employment tax. Another reason is that you may not have enough deductions to itemize so there is no tax benefit gained from the home mortgage interest deduction. And there is the issue of equity interest not being deductible for AMT purposes where business interest is.

Examples – To better understand how these rules play out, let’s apply them to some examples. Let’s assume that you currently have a $200,000 mortgage on your home, all of which is acquisition debt or refinanced acquisition debt. For this purpose, the $200,000 acquisition debt is debt incurred to acquire the home and any debt incurred to subsequently make substantial improvements on the home. The current market value of your home is $500,000.

• Scenario A – You need $150,000 to start your business so you refinance your existing $200,000 mortgage for $350,000 and you do not exercise the unsecured election. During the year, you pay $10,000 of interest on the loans. According to rule #1, you first must allocate the interest to home mortgage interest to the extent allowable as home mortgage interest and then the excess can be traced to your business. Thus, $200,000 of the debt is attributable to refinanced acquisition debt and the next $100,000 of the refinanced debt must be treated as home equity debt. The remaining $50,000 of debt is excess debt and per rule #2 can be traced to your business. Thus, only $1,429 of the $10,000 of interest can be traced to your business. The remaining interest must be treated as home mortgage interest and deducted as an itemized deduction, if you can itemize.

• Scenario B – Same as scenario “A” except you elect to treat the loan as unsecured (Rule #3). Since rule #1 only allows a taxpayer to deduct interest as home mortgage interest on debts that are secured by the home, the interest on the $200,000 of the acquisition portion of the refinanced debt is no longer deductible for any purpose since it is traceable to, but not secured by, the home. However, since the loan is unsecured none of the amount in excess of the $200,000 needs to be treated as equity debt and instead $4,286 ($10,000 x 150/350) of interest from the remaining $150,000 of that debt can be traced to your business. So, although you increased the amount that is deductible as business interest, you lost the amount that could have been deducted as acquisition debt interest.

• Scenario C – Instead of refinancing the first trust deed, you leave it alone and obtain a 2nd TD (or a line of credit) for $150,000. You make the unsecured election for just the 2nd TD. Since the original loan is still secured by the home, the interest on that loan is still allowed and deducted as an itemized deduction as usual. And, since the 2nd TD is treated as unsecured, the interest on that debt can be traced to and deducted on your business. So even though you pay a slightly higher interest rate on a 2nd TD, you will still be able to deduct all of the interest.

These rules can be confusing and require some in-depth planning to ensure you maximize the benefits of the interest deductions based on your overall business needs, existing loan mix and personal tax structure. Please call this office for assistance prior to any refinance, whether it is personal- or business-related, to make sure you get the most from your interest deductions while avoiding pitfalls.

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