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At tax time you might get a deduction for interest paid on mortgage debt, reducing the taxes you pay. It’s like getting cash back on those house payments.
But you only get the deduction if you itemize rather than taking the (new and larger) standard deduction.
And, sadly, most other personal debts don’t give you any advantage. The interest you pay on credit cards, car and boat loans, or other debts usually comes 100% out of your pocket, with no tax savings.
On the other hand, any interest you pay on business debt is tax deductible.
You probably knew that, but do you know how to take advantage of this aspect of tax law?
That’s what we’re going to look at here. And if you don’t already have a small business or side gig, you may want to consider starting one to take advantage of the strategies that follow.
First, we’ll look at why business interest deductions save you so much money. Then we’ll explore a couple simple strategies that effectively replace personal debt with business debt, so you can deduct the interest you pay and save money at tax time.
By the way, this is not an argument for taking on more total debt. I personally try to avoid all debt, personal and business. But if there must be debt, let it be on your business. Here’s why, and how.
Why Business Deductions Save You So Much Money
Let’s say you’re in the 15% income tax bracket. On income from a sole proprietorship (or a pass-through business entity like an LLC) you pay that 15% personal rate plus the 15.3% self-employment tax (for Social Security and Medicare).
The IRS does let you deduct half of the self-employment tax paid, which brings its effective rate down to 14.15% (again assuming your personal rate is 15%), so you pay a total rate of 29.15% on net business income (15% personal rate plus the 14.15% net self-employment tax).
If your state adds another 6% or 7% (or more) income tax to that, you can easily pay 35% or more in taxes.
That sucks! On the other hand it also means that if you can replace a $1,000 personal expense (no deduction) with a business expense (deduction worth 35% tax savings), you’ll save $350 ($1,000 x 35%).
Do that with $5,000 in expenses and you’ll have $1,750 more in your pocket at the end of the year!
Plenty of tax experts (even the IRS) can give you tips for making the cost of travel or other personal activities into deductible business expenses.
Here we’ll focus just on the interest you pay on various debts, how to get back 35% of that at tax time, and how to make those personal debts into business debts in order to save even more.
How to Replace Personal Debt With Business Debt
Let’s say you owe $10,000 on personal credit cards. If you just claim the balances are business debts you might go to jail for tax evasion. And there isn’t a direct way to convert those credit card interest payments into a deductible business expense.
But there is an indirect way, a four-step strategy that will eventually eliminate your personal debt and replace it with business debt. Here it is:
- Borrow for everything you buy for your business.
- Make only the minimum payments required for those business debts.
- Pay yourself all profits as personal income.
- Use the excess cash flow generated this way to pay down your personal debts.
Okay, you probably see what you’re accomplishing here, but let’s spell it out…
First, instead of paying cash for anything in your business, put it all on business credit cards. For example if you buy $200 weekly in supplies for your business, and normally pay by check, cash, or bank transfer, instead pay using your business credit cards.
Why? Because interest paid on business credit cards is tax deductible as long as the charges are valid business expenses. You can also take out business loans or otherwise finance purchases instead of paying cash.
Second, keep payments on those new business debts as small as possible… for now. You can always pay down those debts once you have your personal ones cleared up.
Why make minimum payments? To free up cash flow. For example, if, instead of paying right away for that $200 in supplies each week, you charge them and make a minimum credit card payment of say, 4%, you free up $192 weekly, which brings us to step three…
By borrowing for everything, and making small payments, you have freed up some of the money coming into your business, which you now use to write yourself bigger paychecks, or to take it out as personal draws.
Finally, you use that additional personal cash flow to pay down your personal debts as quickly as possible.
The end result? Eventually your personal debts are gone (assuming that, once paid off, you continue to pay your personal credit cards in full each month), and they’re effectively replaced with business debts.
Since you only borrowed for real business purposes, the interest you pay on all that debt is tax deductible. For every $1,000 in interest you pay now, you’ll save $350 at tax time.
More About the Legalities
I’m not a tax expert (so be sure you get professional advice), but the IRS is pretty clear about deducting business interest. They say:
You can generally deduct as a business expense all interest you pay or accrue during the tax year on debts related to your trade or business. Interest relates to your trade or business if you use the proceeds of the loan for a trade or business expense. It does not matter what type of property secures the loan. You can deduct interest on a debt only if you meet all the following requirements.
- You are legally liable for that debt.
- Both you and the lender intend that the debt be repaid.
- You and the lender have a true debtor-creditor relationship.
Okay, you can’t play games, like paying your mom above-market interest rates to “borrow” for your business. But otherwise, the rule is pretty simple:
If it’s for your business and you borrow for it, the interest is probably deductible.
If you have a more complicated situation, like mortgaging your home to borrow money for business purposes, or taking out a loan with someone else and using only your share for business purposes, you may want to read through IRS Publication 535, or talk to a tax specialist.
Also keep in mind that everything suggested here assumes you’re the sole owner of your business, or perhaps you and your spouse are the owners. Clearly you can’t arbitrarily load the business with debt (or take larger personal draws) if there is another owner.
Moving on to our next strategy…
How to Make New Debts Business Debts
Use the strategy above correctly and you’ll eventually have no personal debt, plus you’ll get tax savings for the interest paid by your business. At that point you might want to pay down those business borrowings too, and be totally debt free (my preference).
But if paying off all of your debt isn’t yet practical, you can at least continue to get the benefit of making all interest payments tax deductible. Just be sure new debt is put on your business.
For example, let’s say that, in the coming months, you plan an ocean cruise vacation and you need to buy a new tractor for your landscaping business. Also, just to keep it simple, let’s say each expenditure will cost you about $8,000.
Furthermore, we’ll say you have very little money in your personal checking account, but a little more than $8,000 in your business account.
Clearly you’re going to have to go into debt for either the cruise or the tractor, so what are you going to do?
Well, by now you know you’re not going to put that cruise on your credit cards.
You’re going to pay yourself a big bonus (say $8,000) from your business and use that money to take your vacation. Then you’re going to finance the purchase of that lawn tractor so the interest payments will be a business expense.
The rule: If you must have debt, make it a business debt to get those tax savings.
Exceptions to the Rule
Sometimes it will make more sense to have personal debts.
For example, let’s say the interest rate is 4% on your car loan. Now, if you can borrow for your business at a similar rate and use the money freed up to pay down the car loan, go for it!
But what if the interest rate is 10% on your best business credit card?
Even if you’re in a high tax bracket you might not save enough from the interest deduction to justify “converting” the car debt into business debt.
For example, if you pay a total of 40% of net profits in taxes, the effective interest rate on a 10% credit card would still be 6% — 2 points higher than the car loan rate.
Yes, you will have to do the math occasionally, because not all interest rates are the same.
Personal credit card interest rates are almost always high enough to justify moving the debt to the business. But for other personal debts, you’ll have to compare them to the effective rate of the business debt interest rate.
To get the effective interest rate (after-tax-savings rate) subtract your total tax rate on business income (federal and state) from 100% and multiply the result by the nominal interest rate you have to pay to borrow.
For example, if you can borrow for your business at 12% and you pay a total of 35% in federal and state taxes on your business income, it looks like this:
100% – 35% = 65%, so…
12% x 65% = 7.8% (the effective rate you pay after tax savings)
So, in this case, if any of your personal debts have an interest rate below 7.8%, you’re better off not adding more debt to the business just to pay them off.
On the other hand, using the tax rates from the example, if you can borrow for your business at 12% and use the freed-up money to pay off a 9% credit card, it does make sense to take on the higher-interest debt, thanks to the tax savings (7.8% effective rate versus 9%).
Do the math, and when appropriate convert personal debts into business debts and/or add new debts to your business rather than personal accounts, and reap the tax savings!
If you have a small business or side gig, will you be able to use these strategies? Please share your thoughts below… and keep on frugaling!