Business Loans and Taxes: Interest, Proceeds, Forgiveness
Why borrowed money is not income and repaying it is not a deduction, how interest and fees are deducted, the tracing rules when loan proceeds are used for several purposes, and what happens when a loan is forgiven.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
Borrowing is not income and repaying principal is not an expense; only interest and fees are deductible, and only to the extent of business use. Outside a C corporation, proceeds used personally or distributed to owners produce interest that is not a business deduction. A forgiven loan is generally taxable income unless an exclusion applies.
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What is deductible, and when?
| Item | Treatment |
|---|---|
| Loan proceeds | Not income |
| Principal repayments | Not deductible; reduce the liability |
| Interest on money used in the business | Deductible as paid (cash method) or accrued (accrual) |
| Loan origination fees, points, closing costs | Amortized over the loan term; remaining balance deducted if the loan is paid off early |
| Prepayment penalties | Deductible as interest when paid |
| Interest on a pass-through entity's loan whose proceeds were distributed to owners | Traced to the owners' use; deductible by them only to the extent they used the money for business or investment |
| Interest on a loan used to buy a vehicle or equipment | Business share deductible; personal share is not a business expense, though for a new personal-use vehicle it may qualify for the separate 2025–2028 car loan interest deduction |
| Interest on a loan to pay personal income tax | Personal, not deductible |
Most small businesses are exempt from the Section 163(j) business interest limit: it does not apply to a business (other than a tax shelter) whose average annual gross receipts for the prior three years are $31 million or less for 2025 tax years or $32 million or less for 2026. Above that, net business interest is capped at 30 percent of adjusted taxable income, which the 2025 law again figures before depreciation and amortization for tax years beginning after 2024.
How does interest tracing work?
Interest follows the use of the money, not the collateral. In a partnership or S corporation, a loan secured by the building but used to pay owner distributions is generally traced to the distributions, so the interest passes to the owners rather than being a business deduction; a C corporation's interest is generally all business interest. Depositing proceeds into a mixed account and spending on both business and personal items requires allocating under the tracing rules. Keeping loan proceeds in the business account and using them for business purchases avoids the problem.
What about government loans?
Disaster loans from the Small Business Administration are ordinary loans: proceeds are not income, interest is deductible, and advances or grants under those programs that were not required to be repaid were excluded from income by statute. Forgiven pandemic-era paycheck protection loans were excluded as well, and the expenses they paid remained deductible. Other forgiveness — a lender settling for less — is cancellation of debt income unless an exclusion applies, such as bankruptcy, insolvency, or, for owners other than C corporations, qualified real property business debt.
What about loans between the owner and the business?
An owner's loan to an S corporation creates debt basis for absorbing losses if it is bona fide debt the corporation owes directly to the shareholder, ideally documented with a note; a guarantee of a bank loan does not until the owner pays on it. A loan from the business to the owner needs a note, interest at the applicable federal rate, and repayment, or it becomes a distribution, a dividend, or wages. Loans between related businesses need the same formality.
Frequently asked questions
Can I deduct interest on a credit card used for the business?
Yes, for the business purchases on it; personal charges' interest is not deductible.
Is a personal guarantee a tax event?
Not until the guarantor pays. A payment on the guarantee is then a loan to the business or, if uncollectible, a bad debt.
Are loan payments shown on the profit and loss statement?
Only the interest. Principal appears on the balance sheet as a reduction of the liability — a common bookkeeping error is expensing the whole payment.
Does refinancing create income?
No, unless the lender forgives principal as part of it. Fees on the new loan are amortized over its term.
Official sources
The IRS explains: “Interest relates to your business if you use the proceeds of the loan for a business expense. It doesn’t matter what type of property secures the loan.” — Internal Revenue Service, Publication 334 (2025), Tax Guide for Small Business, https://www.irs.gov/publications/p334
The IRS explains: “Generally, you must include the canceled debt in your income. However, you may be able to exclude the canceled debt.” — Internal Revenue Service, Publication 4681 (2025), Canceled Debts, Foreclosures, Repossessions, and Abandonments, https://www.irs.gov/publications/p4681
Next step
Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our bookkeeping team books every loan with its amortization schedule so interest and principal land in the right places. See pricing or book a free fit call.
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