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Secure interest deductions by handling loans the right way

by on
in Small Business Tax,Small Business Tax Deduction Strategies

Say you take out a bank loan and place that money in your personal checking account. Then you start to withdraw funds as needed. Over time, you use the account for several different purposes.

You just bought yourself a whole peck of tax trouble.

Why? Tax laws require you to allocate interest expenses based on the specific use of the borrowed funds. Those convoluted rules can lead to a record-keeping quagmire, especially if you mix your loan dollars with other funds.

Strategy: Deposit loan funds in a separate account and use them for a single purpose. Don’t commingle the loan proceeds with other funds. This is the best and most practical approach for avoiding dire tax complications.

Here’s the whole story: The amount of interest you can deduct depends on the way the IRS characterizes your loan. If loan proceeds are used for more than one type of expense, you must allocate the interest based on that use.

Specifically, you must allocate interest to the following categories:
• Business interest.
• Passive activity interest.
• Investment interest expense (such as from a brokerage-house margin loan).
• Qualified residence interest (on loans secured by your first or second home).
• Personal interest.

The interest on a loan is allocated the same way as the loan proceeds. You must allocate loan proceeds by tracing disbursements to specific use.

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 the date the loan is repaid or the date the loan is reallocated to another use.

Generally, you treat loan proceeds deposited in an account as being used before any unborrowed amounts held in the same account or any amounts deposited after the loan proceeds. As you might imagine, tracing the use of funds can become mind-numbing if multiple loans are involved.

Example: Consider the following example, which is laid out in IRS Publication 535 (Business Expenses), at www .irs.gov/publications/p535/ch05.html.

On Jan. 9, Edith opened a checking account, depositing $500 from the proceeds of Loan A and $1,000 of unborrowed funds. The table below shows her annual transactions:

Date        Transaction
Jan. 9       $500 proceeds of Loan Aand $1,000 unborrowed funds deposited
Jan. 13     $500 proceeds of Loan B deposited
Feb. 18    $800 used for personal purposes
Feb. 27    $700 used for passive activity
June 19    $1,000 proceeds of Loan C deposited
Nov. 20   $800 used for an investment
Dec. 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.

30-day rule: If you deposit loan proceeds in an account, you can treat payments made within 30 days from any account as being made from those proceeds (up to the amount of the loan).

Sound complicated? It’s just the tip of the iceberg. Suffice it to say, commingling loan funds generally should be avoided whenever possible.

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