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Small Business Financing: Using Home Equity for Business Needs

by
Sonu Shukla
on
4/26/2017
Small Business Financing: Using Home Equity for Business Needs

If you are a small business owner having a hard time getting the financing you need, you may be considering turning to your personal assets for collateral - and particularly the equity you have in your home. Though doing so may provide an easy answer - particularly with interest rates remaining so low - it is important to make sure that you understand all consequences that this decision may hold.

When a business owner secures financing to either purchase or sustain a business, they are generally able to deduct the interest they pay for that loan. Though when you use your home as collateral for a loan for your business you may be able to take the entire deduction in the same way, but you may also find the deduction is either no longer available or only partially available. 

Allowable Tax Deductions

Tax laws limit the amount of home mortgage interest that you can deduct. You are not permitted to deduct interest on any amount over $1 million spent to purchase your home or designated second home, and if you take out a home equity loan you are not permitted to deduct interest on anything that exceeds $100,000. These allowable amounts are deductible as home mortgage interest if you take itemized deductions, while the amounts that are above the threshold can be attributed to your business as long as you are able to link the expense to the organization.  This makes what you would have assumed to be a simple transaction into a complex one, for the following reasons:

  • Taxpayers who do not itemize their deductions lose the opportunity to deduct the interest they pay on the first $100,000 of their equity debt - and they are not allowed to apply the amount to the business' deduction.
  • Taxpayers whose returns are subject to the alternative minimum tax are also not eligible to deduct the first $100,000 of their home equity interest. AMT does not permit the home equity interest deduction.
  • Business owners who are required to pay self-employment (SE) tax for Medicare and Social Security calculate the amount they owe each year on their business' net profits. When a business owner chooses to use home equity to finance their business loan, they may find that their self employment tax increases because they are not able to deduct the interest on the first $100,000 of their home equity loan.

Example: If a taxpayer borrowed money when they first purchased a $400,000 home and their mortgage balance is $165,000, and they then elect to refinance their home for $315,000 in order to use the additional $150,000 for their new business, the impact would be as follows:

New Loan: $ 315,000  
Part Representing Acquisition Debt <165,000> 52.38%
Balance: $ 150,000  
First $100,000 Treated as Home Equity Debt <100,000> 31.75%
Balance Traced to Business Use $   50,000 15.87%

Given this scenario and interest paid of $10,000 on the new debt, the deductions would break down as follows:

Itemized Deduction Regular Tax $ 8,413 84.13%
Itemized Deduction Alternative Minimum Tax $ 5,238 52.38%
Business Expense $ 1,587 15.87%

There is, however an election available that allows business owners to have their home loans detached from being secured by the home. In doing so they are able to forego deducting home mortgage interest and to trace the interest to the business' use, therefore allowing it to be written off as a business expense.

This can be a highly effective option, but only if it is possible to you can show that all of the proceeds were used for the business. The problem is that if in fact the loan was partially used as a home expense, the business owner loses their ability to allocate that deduction back to the home, as shown here:

Example: Revisiting the calculation from the previous example, if the election is taken and the mortgage is treated as unsecured by the home, the deductible business interest for the year would be $4,762 [($150,000/$315,000) x $10,000]. None of the balance of the interest would be deductible. 

Though using a home equity loan may make sense at first glance, it is important that you understand all of the complex tax ramifications before moving forward. Before moving forward, we suggest that you seek counsel from an experienced tax professional to ensure that the decision you make is right for you and will provide the greatest tax benefit.

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Sonu Shukla

Sonu Shukla

Sonu Shukla is a CPA, accountant, and tax preparer based in Orlando, FL. Sonu Shukla can assist you with your tax preparation and planning needs. Sonu is more than just another accountant in Orlando, Florida; he is a small business owner himself. It is a position in life that grants him the perspective and insight to emphasize with his clients, bringing them the best service possible. A Certified Public Accountant and a Certified Financial Planner, Sonu possesses the skills, education and experience to demonstrate unerring business acumen and passionately planned financial strategies. Being proactive is key for Sonu, tailoring highly efficient tax plans for his small business clients, all in a one on one environment where he and the client can bounce ideas around until every detail is worked out.

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