Loan origination fees are charged at a rate of 0.5% to 1% of the loan value. However, businesses often pay at a rate of 1% to 6%. One question that commonly arises is: “Are loan origination fees tax deductible for a business?”
With the wide variety of lending institutions available today, the fees are at the discretion of the lender. Most non-traditional lending companies allow you to negotiate the origination fees. They will also guide you on fees that are tax deductible and those that are not.
Keep on reading to learn more!
What Are Loan Origination Fees?
A loan origination fee refers to the cost a borrower has to meet towards their application. The charges go to the lender for creating unique loan specifications. It’s also called the loan processing fee or money lending fee.
The origination fees are supposed to offset a lender’s cost of evaluating a loan application. For example, when an individual applies for a mortgage, there are costs involved. The lending institution must assess the income credit score and debt history of the borrower.
In a business loan scenario, the lending bank or institution must also evaluate several factors about the business. The lender must decide on the creditworthiness, loan amount, interest rates, and repayment terms.
After looking at these factors, the lender drafts a loan proposal. This process attracts a specific cost because there are resources involved. The loan origination fee is billed immediately and paid upon signing the loan agreement.
In other arrangements, it can be paid over time inclusive in the monthly installments.
Factors Affecting Loan Origination Fees
The average loan origination fee stands at 1%. The figure varies from one type of loan to another. Determining the actual charge is somehow challenging until some factors come into play.
If the type of loan you seek is the type that most lenders would approve, the origination fee may be low. Lenders will keep you interested by offering low fees if they know you can get it elsewhere quickly.
A loan that has a lengthy approval process and a lot of paperwork may attract higher fees. Some types of loans that would take lenders a long time to approve may attract high origination fees. This knowledge revolves around lenders, and hence they understand the dynamics of each type of loan.
Risky loans aren’t very competitive because not many lenders want to extend them to borrowers. Lenders who issue risky loans are likely to charge higher fees because of the work involved. The risk of default on such loans attracts the higher origination fees.
Most importantly, the loan amount affects the origination fees. The higher the loan you seek, the lower the origination fees and vice versa. With a small loan, the lender earns less from what you borrow and hence compensates with high charges.
Can You Lower Loan Origination Fees?
Loan origination fees are not necessary, and in fact, some lenders don’t charge them. The good news is, whatever the amount of fees charged, you can negotiate a friendly rate. The higher your loan amount, the better your chances are for successful negotiation.
Lenders are usually more willing to negotiate origination fees if the interest rate is high. Although the charge doesn’t lower the interest, it provides the lender with a profit. Alternatively, you may be willing to have a lower upfront fee at the expense of a higher interest rate.
Breaking Down the Loan Origination Fee
As mentioned, loan origination fees cover the costs involved in processing your loan. Some lenders itemize all the expenses involved while others list a lump sum. Each lender uses a different approach to outlining the fees.
Some of the items listed, usually on page 2 of your loan application, are applications fee processing fee, and underwriting fee. Others include charges for document preparation.
Are Loan Origination Fees Tax Deductible for a Business?
As a business owner, you’ll at one point or another seek a loan. Among the issues you may worry about is the interest rate you’re charged. Besides, there is also loan origination fees you must meet.
All these factors, coupled with tax deductions, might make your loan very expensive in the long run. At this point, you might ask, “Are loan origination fees tax deductible for a business?”
Fortunately, YES. You can deduct your loan processing fees from your tax returns.
Unfortunately, many taxpayers aren’t aware that these charges are tax-deductible according to law. The costs are considered interest on the loan and hence you can claim their deduction. The Income Tax Act, Section 2(28a) defines interest as any money payable in respect to money borrowed or debt incurred.
The law recognizes any service fee in respect to loan amount as interest. It’s therefore eligible for deduction.
It doesn’t make a difference whether you pay the interest on a personal loan, bank loan, credit card, or business loan. It also doesn’t matter the collateral used in getting the loan, whether personal or business.
It’s important to note that deduction on interest begins only when the loan gets invested in the business. Borrowed money that stays in the bank is considered an investment and attracts no deduction.
Types of Business Loans that Qualify for Tax Deduction
It’s essential to look at types of business loans in answering the question “are loan origination fees tax deductible for a business?”
Loans you use on personal needs don’t qualify for tax deductions. You can avoid paying this interest whenever possible.
One approach is to use your business to borrow money to pay business expenses. From the money your company earns, you can pay off personal debt. By doing this, you eliminate non-deductible personal interest and replace with deductible business expenses.
The amount of interest you pay on these loans depends on how the lender calculates it. The period of the deduction depends on when you repay the loan. A few other factors around the use of the credit also determine when you can deduct.
Here are some of the business loans that can help you do so.
1. Car Loans
Acquiring a business loan to buy a car for business purposes allows you to deduct the interest from tax. The interest is regarded as an expense and is deductible using the actual expense method. You can also use the standard mileage rate to make the deduction.
If the car is for business purposes only, the law allows you to deduct all the interest. If the car is sometimes used for personal purposes, you can only deduct a certain business percentage.
2. Loans to Purchase a Business
If the loan you borrow is to buy an interest in a partnership or LLC, seek advice on how much interest is deductible. The interest should be allocated among the assets of the company. Its deduction depends on the assets the business owns.
The approach of deduction can be a business expense or investment expense. Interest deducted as an investment expense is more limited.
Money borrowed to buy a C-corporation is regarded as investment interest. This applies to small corporations and those whose stocks are not yet publicly traded.
3. Loans Acquired from Friends
The money you borrow from friends or relatives and use for business purposes is tax deductible. The interest gets deducted as a business expense. Loans between friends and family are treated with some suspicions.
You, therefore, need to record all transactions carefully. It’s best that you treat the loan like any other business loan. To help you achieve this, you can sign a promissory note, and follow a regular payment schedule.
Additionally, strive to pay a reasonable interest rate on loan. Have proof of any canceled loan payments to show that you paid the interest.
4. Term Loans
Terms loans refer to funds issues as a lump sum and deposited directly into your business account. The loan funds are paid on a set regular schedule agreed upon between you and the lender. The term of payment can extend to several years.
The interest on such loans accrues depending on the set rates over time. It typically accumulates with each repayment period. A loan payback schedule will help you calculate how much interest will accrue in a certain repayment period.
Generally, you should deduct interest on a term loan in the corresponding year you made payments. For example, if you take a term loan with a repayment period of three years, deduct interest on tax paid in each of the consecutive years. The amount you deduct should reflect the amount of interest in the three years.
5. Business Lines of Credit
A business line of credit lets you draw from a pre-approved amount of available funds. You will then repay the amount you withdraw within minimum repayment guidelines. You only attract payable interest on the amount you utilize, unlike what happens with a term loan.
Interest on a business line of credit accumulates only when you withdraw from the fund. The amount of interest deduction hence depends on your usage of the funds. Refer to your business line of credit statements before filing your tax returns.
In case something doesn’t make sense, talk to your lender to set the records straight.
6. Short-Term Loans
These types of loans attract a shorter repayment period than other types. Most times, they should be repaid within the same tax year. It means that you’ll deduct all interest paid within the period or split it between two filing periods.
You can calculate the interest on your short-term loan using a factor rate dictated by the terms of the loan. You can also use a standard annual percentage rate (APR) for more accurate results. The method you use will have an impact on the amount of interest deductible.
Deductible Business Interest Expenses
When you borrow to make a purchase, the balance will attract interest. Here are some deductible interest types:
1. Prepaid Interest
Prepaid interest refers to upfront interest payable before the first payable installment. When you have a mortgage on the business property, you’ll have to prepay interest as part of closing costs. For taxation purposes, such interest is expensed over the loan duration.
2. Interest Payable as Part of the Cost of Goods
Purchases made on credit with an interest rate on them should be included in calculations of products sold. The interest on such goods is a non-operating expense. On the income statement, this expense represents accrued interest over the related period of the financial statements.
3. Investment Interest Expenses
Your deduction for this type of interest depends on your net investment income. The interest can’t be higher than the return on your investment.
Most of these interest expenses can be carried over to a future year’s taxes. Keep the records for proper accounting.
Instances When Interest on Tax Isn’t Deductible
In the majority of business loan cases, interest is tax deductible. However, there are certain situations where you’ll not be able to deduct it. Here are a few situations:
When You Refinance a Business Loan
Sometimes, you’ll refinance a business loan to get better terms like lower interest or longer repayment period. The approach will save you money in the long run, but won’t help in tax deductions.
Taking a loan to pay off another loan is not considered a business expense. The interest payable to the original lender won’t qualify for tax deduction. When paying off the new loan, you can start deducting interest again.
When Purchasing Business Property
Loan originating fees charged on a loan you take to purchase a business property can’t get deducted. You’ll have to add the costs to the value of the property, which will be deducted with depreciation.
This also applies to manufacturing and construction loans for businesses worth over $1 million.
An interest that must be added to the principal balance of a business loan can’t be deducted. The expenses accrued from the interest should be depreciated alongside other costs of the business asset.
Final Thoughts: Are Loan Origination Fees Tax Deductible for a Business?
From the above, your question “Are loan origination fees tax deductible for a business?” has been answered. It’s clear that you can benefit from tax relief on interest charged on business loans. Loan origination fees fall under the category of interest.
Although some situations can limit the amount of interest you can deduct, you’ll still save some cash. Most importantly, avoid taking personal loans even if you intend to use them for business.
Should your interest situation be a little complex for you, you can engage an accountant. Go for a professional with vast knowledge in tax codes to guide you effectively.
Do you have any question? Feel free to contact us or call (855) 610-5626.