Tip No. 10: Using Home Equity to Finance a Small Business

If you used a home equity loan to finance your small business, this clever tax move could save you a bundle.

IF YOU'RE A small business owner who's used a home-equity loan, or HEL, to inject some cash into your business, then you probably already know that you're eligible for a nice interest deduction. After all, one of the perks of a HEL is that you can claim a Schedule A itemized deduction for the interest on up to $100,000 of loan principal. But as a small-business owner, you'd most likely be better off taking that deduction on your business tax schedule. Here's why.

When you are the owner of what's known in IRS-speak as a "pass-through entity business," the interest is a fully deductible business expense. This is much better than taking the deduction on your Schedule A (for reasons explained below). (Pass-through entities are sole proprietorship, partnerships, S corporations, LLCs or LLPs — the most common legal forms of small businesses.) Now, if you "materially participate" in the venture (hint: if you run the outfit, you qualify) and used your home-equity loan to add cash to this business, then you are eligible for this maneuver.

To take advantage, you must deduct the interest on the appropriate business tax schedule. That means Schedule C for sole proprietorships and single-member LLCs, and Schedule E for partnerships, S corporations, multimember LLCs and LLPs.

Deducting the interest on Schedule C or Schedule E instead of Schedule A has all the following advantages:

If you do decide to go this route, you must "disclaim" your Schedule A itemized deduction in order to claim the interest write-off on Schedule C or E. To do so, you simply add the following statement to your 1040: "Taxpayer hereby elects to treat the following debt as not secured by taxpayer's residence." Then list the amount of the loan and the name of the lender.

Here's another potential benefit to this strategy: Your full $100,000 home-equity loan tax privilege is saved for another day. Why? Because you didn't treat the current loan (i.e., the one used to infuse cash into your business) as a home-equity loan on your tax return. (By definition, it's still a home-equity loan for general legal purposes.)

Say, for example, that in a year or two you decide to take out another home-equity loan to pay off your auto loan, some credit-card bills and finance a new swimming pool. Regardless of whether you've paid off your other loan, you can once again borrow up to $100,000 and deduct the interest on Schedule A as home-equity loan interest (provided you meet the home-equity loan interest-deduction guidelines).

Of course, with two outstanding HELs, you'd better hope your small business continues to be a smashing success.