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I am running a private lending business (hard money loans).

Hello. I am running a...
Hello. I am running a private lending business (hard money loans). Up until now I have just used the 1099-int to record the income. However, I am thinking to switch this all over to Schedule C. As I look at the new tax laws I see pro's and con's. A lot of the decision comes down to how I can reduce the income on Schedule C to avoid paying high self-employment tax. As I got more involved in private money lending I got a 2nd on our house (HELOC) and I refinanced our first to nearly triple what we owed. We used to just owe $120,000, now we owe about $380K. At the same time that I did this, I started to fund notes that were in excess of the HELOC and amount of debt on the first. Is this sufficient for me to be able to apply part of (or our entire) home interest as a business expense? Or do I need to report all of the home mortgage and HELOC on Schedule A even though my reason for those debts is to provide funds for me to lend?
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Answered in 12 minutes by:
3/9/2018
Lane
Lane, JD, CFP, MBA, CRPS
Category: Tax
Satisfied Customers: 13,980
Experience: Law Degree, specialization in Tax Law and Corporate Law, CFP and MBA, Providing Financial & Tax advice since 1986
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Hi. My name’s Lane …

I hold a law degree (J.D.), with concentration in Tax Law, Estate law & Corporate law, an MBA in finance, a BBA, and CFP & CRPS (Chartered Retirement Plans Specialist) designations, as well - I’ve been providing financial, Social Security/Medicare, estate, corporate, non-profit, and tax advice, to clients on three continents, since 1986.

I’m reading your question now.

Bear with me a moment while I type up my response.

….

Then if you have further questions we can go from there.

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Please don't shoot the messenger here, but you SHOULD already be filing a schedule C. Doing this in pursuit of profit (income) makes you a business, under title 26 of the US code.

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If you haven't filed anything formally with your secretary of state (LLC or Corporation) then you are by default a sole proprietor (unless you have a partner, then you are by default a partnership and file a 1065).

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But in terms of the new code, yes, as a sole proprietor you'll qualify for the new 20% pass-through deduction.

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ALL passthroughs (sole proprietors, LLCs not election corporate taxation, partnerships, and S-Corps (which is really just an LLC or corporate that has filed a tax election - form 2553 - with IRS to be taxed under the S-Corp regime)) get the 20% deduction.

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This was done under the new cold to level the playing for having already given the regular corporation (S-Corps) the lower 21% tax bracket.

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So regardless of getting yourself compliant by filing as a business, you'll certainly do better

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The TCJA creates a brand new tax deduction for individuals who earn income through pass-through entities (new IRC Sec. 199A). If your activity qualifies as a business for tax purposes, (you do) you're eligible to deduct an amount equal to 20% of your net business income.

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(Filing the schedule C, by the way, makes ALL f your business deductions 10% deductible, rather than having to qualify as an itemized deduction, a much higher - more limited - hurdle under the new law as well)

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You qualify for an income tax deduction equal to 20% of your rental income if:

  • you operate your rental business as a sole proprietor, LLC owner, partner in a partnership, or S corporation shareholder, and
  • your total taxable income for the year from all sources after deductions is below $315,000 if you’re married filing jointly, or $157,500 if you’re single
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Please let me know if you have ANY questions at all, before rating me.

If this has helped, and you DON’T have other questions … I'd appreciate a positive rating (using the stars on your screen, and then clicking “submit")

That’s the only way JustAnswer.com will credit me for the work.

But again, let me know if you need more here,

Lane

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Customer reply replied 1 month ago
Thanks for the info. I was already pretty much aware of all these points. I would disagree a bit that it is necessary for me to file a Schedule C; there is an argument that hard money lending is passive because the loans are brokered by a 3rd party and serviced by another 3rd party, but your opinion is also valid; that it is a business. But anyway, my original question was not to ask about this, it was to ask about the validity of using HELOC and Home Mortgage as business expense if I can demonstrate the timing for creating these loans coincided with my lending those amounts (and more). In other words, I want to put all my interest expense (HELOC, Home Mortgage and money I borrow from another source) as expenses to offset income on my Schedule C. But, the 1040 steers me to put all Home Mortgage interest on Schedule A. The reality is, if I was not lending out this money I would not have increased my mortgage from $100,000 to $300,000. I realize this is probably a grey area, but still seeking advice. Thank you

Understand ... The only real definition IRS gives is as follows (from: https://www.irs.gov/businesses/small-businesses-self-employed/deducting-business-expenses#other)

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(I'll underline the pertinent part)

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Other Types of Business Expenses

  • Employees' Pay - You can generally deduct the pay you give your employees for the services they perform for your business.

  • Retirement Plans - Retirement plans are savings plans that offer you tax advantages to set aside money for your own, and your employees' retirement.

  • Rent Expense - Rent is any amount you pay for the use of property you do not own. In general, you can deduct rent as an expense only if the rent is for property you use in your trade or business. If you have or will receive equity in or title to the property, the rent is not deductible.

  • Interest - Business interest expense is an amount charged for the use of money you borrowed for business activities.

  • Taxes - You can deduct various federal, state, local, and foreign taxes directly attributable to your trade or business as business expenses.

  • Insurance - Generally, you can deduct the ordinary and necessary cost of insurance as a business expense, if it is for your trade, business, or profession.

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Just as with any OTHER expense, the source of the financing isn't the issue, it's the use of the proceeds that determine whether something is a business expense or not.

...

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If you get push back (and that's what we're talking about, what would happen in the case of an audit) things will very likely turn on your direct involvement.

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I don't think you have an issue around whether this is used to generate income, hence a business activity, the rub (as you've pointed out) may be the broker and servicer issues.

...

Lane
Lane, JD, CFP, MBA, CRPS
Category: Tax
Satisfied Customers: 13,980
Experience: Law Degree, specialization in Tax Law and Corporate Law, CFP and MBA, Providing Financial & Tax advice since 1986
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Lane and 87 other Tax Specialists are ready to help you
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Customer reply replied 1 month ago
Thanks. ***** have read this as well. So far I am pretty much up on all of this. But this still leaves my question; "is it going to fly?". I can demonstrate that I made loans at the same time as I increased my mortgage. So I am not worried about proving the link. What I am worried about is that the IRS may have a firm position that home mortgage cannot be implied for use as a business expense. I guess I'm looking for your opinion here, not just what is written, as I think this is a grey area since Schedule A is set up for that deduction and lenders report it as such for cross-matching. I'm likely to be audited since there wn't be a Schedule A match; and that is ok, I file my taxes carefully, but I do want to prevail so I want to know if i'm more or less on the right side of the topic. any input?

" What I am worried about is that the IRS may have a firm position that home mortgage cannot be implied for use as a business expense."

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NO, again, it's the USE of the proceeds that drives whether the expense is a business expense under §162 .

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As an example, think about the Home office deduction. IF you USE the space regularly and exclusively for business you are allowed to deduct that proportionate amount of all home expenses (INCLUDING mortgage interest).

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The financing might be a bank underwriting issue, but what the tax law (and on this issue, tax court cases and IRS' position on this - IRS only administers the law - congress writes it - and their position changes from time to time time when U.S. tax court, federal district court, and US supreme court cases changes their mind FOR them) says AND IRS's position on this has long been settled.

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Financing source does not determine whether something is a business expense. Use of the proceeds determine whether something is a business expense.

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For something to be a business expense it must be (another item not stipulated in the code but well settled in the low) "ordinary and necessary."

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Necessary

In McCulloch v. Maryland, 17 U.S. 4 Wheat. 316 316 (1819), separately defined the term necessary in a non-rigorous sense as frequently importing "no more than that one thing is convenient, or useful, or essential" or "appropriate". It rejected the limited meaning that a necessary thing had to be absolutely necessary or indispensable

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This landmark case's interpretation of the word necessary is referenced again and again in subsequent court cases involving taxation. Welch v. Helvering, 290 U.S. 111 (1933) references MuCulloch v. Maryland in its assumption "that the payments to creditors of the Welch Company were necessary for the development of the petitioner's business, at least in the sense that they were appropriate and helpful."

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Even IRS has made this statement here: https://www.irs.gov/businesses/small-businesses-self-employed/deducting-business-expenses

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Under "What Can I Deduct?" you'll see (again, I'll underline the pertinent part)

"To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary"

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In terms of ordinary? I would survey other hard moneyb lenders to see what's been deducted and allowed by them in the past.

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This should, altogether. give you something to hang your hat on

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Thanks for the rating,

...

Lane

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Customer reply replied 1 month ago
great info. truly

Glad to help

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Lane
Lane
Lane, JD, CFP, MBA, CRPS
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Satisfied Customers: 13,980
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