Cash-strapped entrepreneurs often find themselves turning to personal sources of funding for their businesses, whether that’s personal credit cards or a personal loan. Also on that list of financing sources: home equity loans or lines of credit (HELOC). These loans can be easier to get than some small business loans (especially for startups), interest rates are often lower than unsecured loans, and best of all, the interest may be tax deductible.
The new tax law takes something of a swipe at home loan deductibility, however, and small business owners need to understand how to navigate these changes.
Some websites have reported that home equity loans are no longer tax deductible. That’s false. But there are new restrictions that may mean fewer taxpayers can take this deduction. Real estate journalist Ken Harney explained it this way:
HELOCs, as well as second mortgages, should still be deductible if homeowners ‘“use the proceeds of the loan to make ‘substantial improvements’ to their home, and the combined total of their first mortgage balance and their HELOC or second mortgage does not exceed the new $750,000 limit on mortgage amounts qualified for interest deductions. (The previous ceiling was $1.1 million for the first mortgage and home-equity debt combined.)”
For tax year 2018, the standard deduction is $12,000 for single individuals and married individuals filing separately; $18,000 for heads of households; and $24,000 for married couples filing jointly.
Small Business “Loophole” Tightens
Small business owners have had more leeway when it comes to deducting interest because interest charged on business loans is often deductible. But that’s changing too.
As Wolf Richter, CEO of Wolf Street Corp. explains in this Business Insider article:
“Starting in 2018, a company can only deduct interest expense of up to 30% of its EBITDA (earnings before interest, taxes, depreciation, and amortization). Any amount in interest expense beyond it will no longer be deductible.
“This will tighten further in 2022, when the deductibility of corporate debt will be capped at 30% of earnings before interest and taxes but after depreciation and amortization expenses. This is a much smaller number than EBITDA. And interest expense deduction is capped at 30% of that much smaller amount. This will raise the tax bill further.”
He goes on to warn that highly leveraged companies will feel the impact of these limits the most, but that “all profitable companies with significant debt levels will feel it.”
What do these changes mean for small business owners who are looking for financing in 2018 and have home equity they may want to leverage?
Be Careful Mixing Business & Personal Finances
You may still be able to deduct home equity loan interest if the loan proceeds are used in your business, but be careful. It’s important to separate business and personal finances, and loans are one aspect of that.
Home equity loans and lines of credit are secured by your home. If your business fails, you can lose your home. Try to build business credit and secure financing in the name of your business without personal guarantees or personal collateral when possible to avoid tying your business too closely to your personal finances. Sometimes it’s inevitable, but do what you can to set your business up for success.
“Take out a separate business loan rather than muddying the waters with a loan associated with a personal asset,” suggests Cathy Derus, CPA, owner of Brightwater Accounting. “I know it might be easier for some business owners to access capital through a HELOC vs. a business loan, but it’s cleaner from an accounting and tax deduction perspective to have a separate business loan.”
Be Aware of ‘Tracing Rules’
If you decide to go the home equity route, be aware of the “tracing rules” found in Treasury Regulation 1.163-8T. As this blog post by the law firm Capell Barnett Matalon & Schoenfeld explains, “tracing rules… allocate debt and interest depending on the type of expenditure to which the proceeds are applied. The underlying property used to secure the loan is generally irrelevant; only the loan’s use is significant (subject to a limited exception for qualified personal residences).” Consulting a tax advisor is wise so you don’t run afoul of these rules.
Derus recommends depositing the loan proceeds directly into your business bank account and making payments from the business.
Take the Time to Shop Rates
Even if it’s tax deductible, interest costs your business money, so you want to shop around for the lowest interest rate and the type of financing that best fits your needs. Small business lenders are not required to disclose an Annual Percentage Rate (APR) so comparing costs of various financing options can be confusing. Free small business loan calculators like these can help.