Often times, small business owners find difficulties in obtaining financing for their businesses without putting their personal assets up as collateral. With this, tapping into your home equity is a tempting alternative but should be carefully considered.
In general, interest on debt used to acquire and operate your business is deductible against that business. However, debt secured by your home may be nondeductible, only partially deductible or fully deductible against your business.
Home mortgage interest is limited to the interest on $1 million of acquisition debt and $100,000 of equity debt secured by a taxpayer’s primary residence and designated second home. The interest on the debts within these limits can only be treated as home mortgage interest and must be deducted as part of your itemized deductions. Only the excess can be deducted for your business, provided that the use of the funds can be traced to your business use. This creates a number of problems:
- Using the Standard Deduction – If you do not itemize your deductions, you will be unable to deduct the interest on the first $100,000 of the equity debt, which cannot be allocated to your business.
- Subject to the AMT – Even if you do itemize your deductions, if you happen to be subject to the alternative minimum tax (AMT), you still would not be able to deduct the first $100,000 of equity debt interest, since it is not allowed as a deduction for AMT purposes.
- Subject to Self-Employment (SE) Tax – Your self-employment tax (Social Security and Medicare) is based on the net profits from your business. If the net profit is higher, because not all of the interest is deductible by the business, your SE tax may also be higher.
Example: Suppose the mortgage you incurred to purchase your home (acquisition debt) has a current balance of $165,000 and your home is worth $400,000. You need $150,000 to acquire a new business. To obtain the needed cash at the best interest rates, you decide to refinance your home mortgage for $315,000. The interest on this new loan will be allocated as follows:
New Loan: $ 315,000
Part Representing Acquisition Debt <165,000> 52.38%
Balance $ 150,000
First $100,000 Treated as Home Equity Debt <100,000> 31.75%
Balance Traced to Business Use $ 50,000 15.87%
If the interest for the year on the refinanced debt was $10,000, then that interest would be deducted as follows:
Itemized Deduction Regular Tax $ 8,413 84.13%
Itemized Deduction Alternative Minimum Tax $ 5,238 52.38%
Business Expense $ 1,587 15.87%
There is a special tax election that allows you to treat any specified home loan as not secured by the home. If you file this election, then interest on the loan can no longer be deducted as home mortgage interest, since tax law requires that qualified home mortgage debt be secured by the home. However, this election would allow the normal interest tracing rules to apply to that unsecured debt. This might be a smart move if the entire proceeds were used for business and all of the interest expense could be treated as a business expense. However, if the loan were a mixed-use loan and part of it actually represented home debt (such as a refinanced home loan), then the part that represented the home debt could not be allocated back to the home, and the interest on that portion of the debt would become nondeductible and would provide no tax benefit.
As you can see, using equity from your home can create some complex tax situations. Please contact Dagley & Co. for assistance in determining the best solution for your particular tax situation.
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Run your own business but things aren’t working out the way you pictured? Thankfully, many proven methods exist to help small businesses increase revenues, cut costs and improve overall. If you’re ready to take your company to a new level of success, consider implementing one or more of the following Dagley & Co. insane (but true) ways to grow small business profits:
Eliminate Low-Margin Clients, Products or Services
To boost your small business profits, ask yourself the following questions:
What clients, products or services generate the most money and offer the greatest growth potential right now?
What clients, products or services generate the least profit and provide the least growth potential currently?
After analyzing your findings, eliminate low-margin clients, products and services. With the saved time and money, focus on the higher-producing areas of your business. Purging clients, products or services from your company might be painful at first. However, this practice will likely slash stress and pay dividends in the long run.
Embrace technology, automate and go paperless. Besides helping the environment, you’ll probably save a ton of money. In addition to cutting costs on paper, you’ll also spend less money on printer maintenance and toner as well as file cabinets and binders.
Increase Conversion Rates Through A/B Testing
Regardless of what type of small business you have, turning more shoppers into buyers will improve your bottom line. To increase conversion rates, consider implementing A/B testing. Also referred to as split testing, A/B testing utilizes two distinct sales pages in order to ascertain which page converts more effectively. Depending on the nature of your business, converting might equate to a customer buying a product or a client purchasing a service.
Experiment With Pricing
Raising prices while adding value can perhaps be the simplest way to improve small business profits. However, you risk losing bargain-oriented customers. Fortunately, for many people, price isn’t the most important factor when purchasing products and services. Lowering prices with the express intent of selling more products or services can also be a winning strategy.
Increase Average Lifetime Value of Each Client
Repeat customers can help your small business survive during stagnant economic times. Besides searching for effective ways to attract new customers, focus on increasing the average lifetime value of each client. You can accomplish this important task by:
- Offering loyal customers a product or service upgrade
- Providing customers with something your competitors don’t offer them
- Being more convenient than your competitors
- Looking for ways to solve problems for your customers
- Providing stellar customer service
- Reduce Churn Rates
Churn refers to when a client ends his or her relationship with a business. A high churn rate will negatively impact your ability to grow your small business profits. To reduce churn rates:
- Establish customer expectations and strive to meet or exceed them
- Make your first impression a great one
- Listen to your clientele
- Closely monitor external environment changes
- Speed Up Product or Service Delivery
Speeding up the delivery of your products and services is another ingenious way to improve profits. Fast deliveries make customers happy and encourage repeat business. Decreasing the amount of time projects sit in limbo will also save money.
Bundle Products or Services
Do you offer products or services that naturally fit together? Providing customers with product or service bundles is a great way to increase both your revenues and your bottom line. For example, an accounting firm might bundle bookkeeping, tax preparation and consulting services.
Expand to a New Geographic Market
If you’ve saturated your current geographic market, consider expanding to a new one. Obviously, the costs of such an undertaking must be analyzed. But the long-term benefits of tapping into new geographic markets might make the venture worthwhile.
Provide Maintenance Contracts
Do you want to generate a steady income stream for an extended period of time? Think about charging customers an ongoing fee in exchange for maintenance contracts. You can even offer discounts to customers who sign longer contractual agreements. When developing maintenance contacts, clearly list the products or services customers can expect to receive.
Growing small business profits may seem impossible to most. Dealing with saturated markets and a sluggish economy can dampen your overall outlook. Struggling to improve the bottom line of your small business? consider adhering to one or more of these strategies above by Dagley & Co., or give us a call at 202-417-6640 for guidance.
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