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My father loaned me money to invest in a company and the company pays me quarterly profits. I have to pay back the loan to my father plus interest. What I would like to know is whether or not the interest I pay to my father is tax deductible. Someone had told me that agreements like these between family members doesn't allow for it, but is that true?

And secondly, if the answer to the first part is no it is not tax deductible, do I have to pay taxes on the interest I pay to my father, as well, does my father have to pay taxes on the interests he collects from me?

I would love an answer to this question but sources/citations would be even better.

  • Well at least the part "you pay taxes for the interest you pay to your father" seems highly improbable to me. – Ghanima May 12 '15 at 22:29
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When you pay interest on a loan used to fund a legitimate investment or business activity, that interest becomes an expense that you can deduct against related income.

For example, if you borrowed $10k to buy stocks, you could deduct the interest on that $10k loan from investment gains. In your case, you are borrowing money to invest in the stock of your company. You would be able to deduct the interest expense against investment gain (like selling stock or receiving dividends), but not from any income from the business. (See this link for more information.)

You do not have to pay taxes on the interest paid to your father; that is an expense, not income. However, your father has to pay taxes on that interest, because that is income for him.

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Can you deduct interest paid to your father on your personal income taxes? Interest paid on passive investments can be deducted from the amount earned by that investment as an investment expense as long as the amount earned is greater than the total paid for the interest expense. Also beware if the amount of interest paid is greater than the yearly gift tax exclusion, as the IRS might interpret this as a creative way of giving gifts to your father without paying gift tax.

Do you pay taxes on the interest you pay? No, because is an expense, not income, you would not count interest paid to him as taxable income.

Does your father owe taxes on the interest he collects from you? Yes, that is income to him.

And the last question you didn't ask, but I expect it is implied: Do you owe taxes on the quarterly profits? Yes, that is income to you.

The Forbes article How To Arrange A Loan Between Family Members is a bit dated, but still a good source of information. You really should write a formal note (signed by both you and your father) indicating the amount borrowed, the interest rate you are paying on that amount, and when the loan will be repaid. If your father has set the interest rate too low, this could also be considered a gift to you, though we would really be talking about large amounts of money to hit the gift tax limit on interest alone.

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    If the interest on the loan from the father is an expense on an investment, then why is it not deductible? If taxes are due on the profits from the investment then surely any expenses to earn that income would be deductible against that income! – Victor May 13 '15 at 1:12
  • Agree with Victor, you can definitely deduct interest expense for loans used for investments (with certain limitations) – littleadv May 13 '15 at 4:03
  • In regards to your last point about taxes on the quarterly profits, the quarterly profit comes to me and I know I have to pay tax on it, but do I pay tax on it before or after I deduct the interest to my father? – user6291 May 13 '15 at 15:01
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    The first paragraph is misleading in several ways. Investment interest expense is deducted on Schedule A, Line 14 and so is not available to those taking the standard deduction. The deduction can be applied against total investment income (dividends and STCG and, at the option of the taxpayer, to LTCG and LT gains from disposition of property also; see Form 4952 for details), not just the income from the investment of the loan proceeds. If the interest exceeds investment income, balance can be carried forward and deducted in later years. – Dilip Sarwate May 14 '15 at 1:17
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    "You subtract the interest paid to your father (not including any principal repayments) from the quarterly profit and pay the taxes on the remaining amount." This is wrong advice. – Dilip Sarwate May 14 '15 at 14:08
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Assuming USA:

It is possible to make the interest deductible if you go to the trouble of structuring, and filing, the loan as an actual mortgage on a primary residence. Websearching "intra-family loan" will find several firms which specialize in this. It costs about $700 for all the paperwork and filing fees as of last time I checked, so unless you're going to pay at least three times that in interest over the life of the loan it probably isn't worth considering. (For an additional fee they'll take care of the payment processing, if you'd really rather be hands-off about it.)

I have no idea whether the paperwork fees and processing fees can be deducted from the interest as a cost of producing that income. In theory that ought to be true, but I Am Not A Lawyer. Or accountant.

Note: one of the interesting factors here is that the IRS sets a minimum interest rate on intra-family loans. It's pretty low (around 0.3%), so in most cases you can say you gifted the difference if you'd prefer to charge less... but that does set a floor on what the IRS will expect the lender to declare, and pay taxes on.

There's a lot more that can be said about this, but since I am NOT an expert I'll refer you to those who are. I have no affiliation with any of this except as a customer, once; it seemed pretty painless but I can't claim to know whether they were really handling everything exactly correctly. The website seemed to do a pretty good job of explaining what choices had to be made and their effects, as well as discussing how these can be used to avoid excess gift taxes by spreading the gift over a number of years.

  • The first paragraph is incorrect. Interest paid on a mortgage is tax-deductible only for mortgages on the primary personal residence and one other personal residence. There is no suggestion by the OP that this is a mortgage on a personal residence. – Dilip Sarwate May 13 '15 at 2:45
  • Correction accepted. However my point is that if the loan can be (re)written as a mortgage this option does exist. Unless you're moving tens of kilobucks or more, I would assume it isn't worth the effort... but it's one of those oddities worth knowing about when a family member needs a hefty amount of cash. It's worth putting the loan down on paper in any case, both for everyone's dignity and to make expectations very clear. – keshlam May 13 '15 at 2:53

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