How business loan interest deductions work

Interest on money borrowed for the business is deductible in full. That much is well known. What decides the outcome in practice is not the loan agreement or what the bank called the product. It is what the money was actually spent on.

The test

Interest is deductible where four things hold. There is a legal obligation to pay it. The rate is reasonable. The interest is paid or payable in the year. And the borrowed money was used for the purpose of earning income from a business or property.

The fourth condition does the work, and it is applied by tracing. CRA looks at where the borrowed dollars went, not at the name on the account. A loan drawn on a business line of credit and used to buy a cottage produces no deduction. A personal loan used to buy inventory does.

Typical qualifying uses:

• Equipment, machinery and vehicles used in the business
• Inventory
• Premises, and the fit-out of them
• Working capital and operating costs
• Buying shares of a corporation that has a reasonable expectation of paying dividends

What the deduction is actually worth

A deduction saves you tax at your rate, so the value of deductible interest is the interest paid multiplied by the marginal rate that applies to the income it shelters.

For an Ontario corporation, that rate depends on whether the income falls under the small business limit or above it, and the two rates are far apart. For an unincorporated business, it is the owner's personal marginal rate, which can be more than double the small business rate. The same $3,000 of interest is therefore worth very different amounts depending on the structure it sits in. Check the current rates for your situation rather than assuming a round number, because the corporate rates have moved and the small business limit is reduced where passive investment income is high.

The useful way to think about it is effective cost. Deductible interest at 7%, in a business paying tax at the Ontario small business rate, has an after-tax cost a little over 6%. In a sole proprietorship at a top personal rate, the same 7% costs closer to 3.5% after tax. That difference is a real input into how you structure financing.

Mixed use is where deductions get lost

The most common problem we see is one line of credit doing everything. Business supplies on Monday, groceries on Tuesday, a payment to the corporation on Friday. Once the borrowings are commingled and repayments start flowing through, tracing becomes difficult and the position is hard to defend.

Borrow $100,000 and put $75,000 into the business and $25,000 into a home renovation, and 75% of the interest is deductible if you can show the split. If the records will not support the split, the whole claim is exposed rather than just the personal quarter.

The fix is structural and it costs nothing. Separate facilities for separate purposes. Business borrowing goes through a business account and pays business costs. Personal spending comes from personal cash and personal credit. Where you have both a deductible and a non-deductible balance, apply free cash to the non-deductible one first.

There is a related technique of routing business operating costs through a line of credit while using operating cash to pay down a non-deductible mortgage. It works, and it depends entirely on clean tracing through separate accounts. It should be set up with advice rather than improvised.

Fees are not interest

The original wisdom that "loan fees are deductible too" is half right, and the half that is wrong causes reassessments.

Financing costs such as application fees, standby charges, guarantee fees, registration costs, and legal and accounting fees incurred to arrange the borrowing are generally deductible over five years, at 20% a year, rather than in the year paid. Where the loan is repaid early, the unamortised balance can usually be taken in the year of repayment.

Compound interest, meaning interest on unpaid interest, is only deductible when it is actually paid, not when it accrues.

Legal fees to negotiate the underlying purchase are a different item again, and often form part of the cost of the asset rather than a financing cost.

When the source disappears

If you borrow to buy an asset and the asset is later sold or becomes worthless, the borrowed money no longer has an income-earning use, and the interest would ordinarily stop being deductible. There is a specific rule that deems the borrowing to continue to be used for income-earning purposes in certain circumstances, so the deduction can survive. It has conditions, and proceeds from the disposition that were not applied to the loan reduce the amount that carries over.

Businesses wind down operations and repay debt in the wrong order all the time. It is worth checking before the transaction rather than at the next year end.

What to keep on file

• The loan agreement, with the rate and terms
• Statements showing interest paid, separated from principal
• Evidence of where the proceeds went, meaning invoices, transfers and purchase documents
• A written record of any allocation between business and personal use

The documentation requirement is not onerous while the money is moving. It becomes close to impossible to assemble three years later, which is roughly when the question tends to arrive.

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General information only, current at August 2026. Tax rules change and GST/HST status is fact-specific. Confirm your own position before relying on anything here.