Tax Implications of Commercial Loan Types

How Do Different Commercial Loan Types Affect Your Tax Liability?

The tax consequences of commercial real estate financing vary significantly depending on which loan structure you choose. A bridge loan creates different deduction opportunities than a permanent loan, and SBA financing carries its own set of fee deduction rules. Understanding these differences before you close can save tens of thousands of dollars at tax time.

This guide breaks down the tax implications of every major commercial loan type, including interest deductibility rules, capitalization requirements, refinance proceeds treatment, and loan modification consequences. Use it alongside our commercial mortgage calculator to model your after-tax cost of capital accurately.

Which Commercial Loan Interest Payments Are Fully Deductible?

Interest expense is typically the largest tax deduction available to commercial property owners, but the rules for deducting it depend on the loan type and how the property is being used.

General Rule Under IRC Section 163: Interest paid or accrued on debt used to acquire, construct, or improve commercial real estate is deductible as a business expense in most cases. However, the timing and method of that deduction varies by loan category.

For permanent loans and DSCR loans, interest is generally deductible in the tax year it is paid or accrued. Monthly mortgage payments on a stabilized, income-producing property create straightforward interest deductions reported on Schedule E or the entity's tax return.

Bridge loans follow the same deductibility principle when the property is already in service and generating income. If you take a 12 to 18 month bridge loan on an operating multifamily property, every interest payment is deductible in the period it occurs.

Conduit loans (CMBS) also produce fully deductible interest. The fixed-rate nature of conduit debt means you can predict your interest deduction years in advance, which is valuable for long-term tax planning.

Key Exception: When borrowed funds are used for construction or substantial renovation of property not yet placed in service, interest must be capitalized rather than deducted currently. This rule, covered in detail below, applies regardless of the loan label.

What Are the Interest Capitalization Rules for Construction Loans?

Construction loan interest follows a fundamentally different tax treatment than interest on loans for operating properties. Under IRC Section 263A (the Uniform Capitalization rules, or UNICAP), interest incurred during the construction period must be capitalized into the cost basis of the property.

What Capitalization Means: Instead of deducting interest as a current expense, you add it to the property's depreciable basis. You then recover that interest expense over the property's depreciation period, which is 39 years for commercial buildings or 27.5 years for residential rental property.

When Capitalization Starts: Interest capitalization begins when construction activity starts (the "production period") and ends when the property is placed in service, meaning it is substantially complete and ready for its intended use.

Practical Impact: On a $5 million construction loan at 9.5% interest over a 14-month build, you would capitalize approximately $554,000 in interest. Rather than deducting that amount immediately, you would depreciate it over 39 years at roughly $14,200 per year for commercial property.

This rule applies to all construction financing, regardless of whether you label it a construction loan, a draw-based facility, or a bridge loan used for ground-up development. The IRS looks at how the funds are used, not what the loan product is called.

Mixed-Use Timing: If part of a property is placed in service before other portions, you can begin deducting interest allocable to the completed portion while continuing to capitalize interest on the remainder.

How Does SBA Loan Fee Deductibility Work?

SBA loans carry unique fees that other commercial loan types do not, and the tax treatment of those fees follows specific rules.

SBA Guarantee Fee: The guarantee fee (ranging from 0% to 3.75% of the guaranteed portion) is deductible, but the timing depends on the fee amount and the loan term. For most SBA 7(a) and 504 loans, the guarantee fee is amortized over the life of the loan rather than deducted in a lump sum at closing.

SBA 504 Program Fees: The 504 program involves a CDC (Certified Development Company) processing fee, a funding fee, and ongoing servicing fees. The processing fee and funding fee are typically amortized over the loan term. Annual servicing fees are deducted in the year paid.

Packaging and Closing Fees: Legal fees, appraisal costs, and other third-party expenses related to obtaining an SBA loan are treated as loan origination costs. Under IRC Section 461, these must be amortized over the loan term for accrual-basis taxpayers. Cash-basis taxpayers may also need to amortize depending on the materiality and nature of the cost.

Points and Origination Fees: Loan origination fees paid to the lender are amortized over the loan term. For a 25-year SBA 504 loan with $18,750 in origination fees, you would deduct $750 per year for 25 years.

SBA Loan Prepayment Penalties: If you prepay an SBA loan and incur a prepayment penalty, the penalty is deductible in the year paid. Additionally, any remaining unamortized loan costs from the original financing become deductible in the year of prepayment.

Explore your SBA options with our SBA loan programs and read our SBA loan refinancing guide for more on optimizing your SBA tax position.

Are Commercial Refinance Proceeds Taxable Income?

No. Refinance proceeds are not taxable income. This is one of the most powerful tax strategies in commercial real estate, often called the "refinance and hold" approach. Here is why it works.

The Core Rule: Loan proceeds are not income because they create a corresponding liability. When you refinance a $2 million loan balance into a $3 million loan (based on increased property value), the additional $1 million you receive is borrowed money, not income. You owe it back, so the IRS does not treat it as a taxable event.

Cash-Out Refinance vs. Sale: If you sold the same property for a $1 million profit, you would owe capital gains tax (potentially 20% federal plus state taxes and depreciation recapture at 25%). By refinancing instead, you access the equity tax-free while retaining ownership and all associated depreciation deductions.

Interest Deductibility on Cash-Out Proceeds: The interest on refinanced debt remains deductible as long as the debt is secured by the commercial property and the total debt does not exceed the property's fair market value. The use of the cash-out proceeds does not affect the deductibility of interest on the portion that refinances existing acquisition debt.

Refinance Cost Deductions: Costs associated with the refinance (appraisal fees, title insurance, legal fees, origination points) must be amortized over the term of the new loan. If the old loan had unamortized costs remaining, those can be deducted in the year the old loan is paid off.

For a deeper look at commercial refinance strategy, see our commercial refinancing guide. Use our commercial mortgage calculator to model your cash-out refinance numbers.

Talk to a Clearhouse lending advisor about your refinance strategy.

How Does Recourse vs. Non-Recourse Debt Affect Tax Treatment?

The distinction between recourse and non-recourse debt has significant tax implications, particularly for pass-through entities (LLCs, partnerships, S-corps) where debt allocation affects each partner's ability to take deductions.

At-Risk Rules (IRC Section 465): Taxpayers can only deduct losses up to the amount they have "at risk." For recourse debt, the borrower is personally liable, so the full loan amount counts as at-risk. For non-recourse debt, only certain "qualified non-recourse financing" secured by real property counts as at-risk.

Qualified Non-Recourse Financing: Non-recourse debt from a bank, regulated financial institution, or government entity (like an SBA loan) that is secured by real property used in a trade or business qualifies. This means most commercial real estate non-recourse loans from institutional lenders still allow the borrower to include the debt in their at-risk amount.

Partnership Debt Allocation (IRC Section 752): In partnerships and multi-member LLCs, how debt is allocated among partners determines each partner's basis for taking deductions.

• Recourse debt is allocated to the partner who bears the economic risk of loss (typically the guarantor or managing partner).
• Non-recourse debt is allocated among all partners based on their share of profits, minimum gain, or Section 704(b) allocations.

Practical Impact: A limited partner in a real estate partnership with non-recourse debt gets basis from their share of that debt, allowing them to deduct more losses. With recourse debt, only the guaranteeing partner gets that basis benefit.

Cancellation of Debt Income: When non-recourse debt is forgiven (such as in a loan workout), the tax treatment differs from recourse debt forgiveness. Non-recourse debt cancellation in excess of the property's fair market value is treated as gain from disposition of the property, not as ordinary cancellation of debt income.

What Tax Events Can a Loan Modification Trigger?

Loan modifications are common in commercial real estate, but they can trigger unexpected tax consequences if the modification is significant enough to be treated as a debt exchange.

The "Significant Modification" Test (Treasury Regulation 1.1001-3): The IRS treats a significant modification of existing debt as a deemed exchange of the old debt for new debt. This can trigger several tax consequences.

A modification is "significant" if it changes any of the following beyond specified thresholds:

• Interest Rate: A change in yield exceeding the greater of 25 basis points or 5% of the original yield
• Timing of Payments: A deferral of payments that exceeds the lesser of 5 years or 50% of the original term
• Obligor: A change or addition of a new borrower (with some exceptions for related parties)
• Collateral: A substantial change in the property securing the debt
• Nature of Instrument: Conversion from recourse to non-recourse or vice versa

Tax Consequences of a Deemed Exchange:

1. Unamortized Loan Costs: The remaining balance of unamortized origination fees and costs from the original loan become deductible in the year of the deemed exchange.
2. Cancellation of Debt Income: If the principal balance is reduced, the forgiven amount may be taxable as ordinary income (subject to insolvency and bankruptcy exceptions).
3. New Amortization Schedule: Any fees or costs associated with the modified loan begin a new amortization period based on the modified loan's term.
4. OID Rules: If the modification creates original issue discount (OID), the borrower may have additional interest deductions spread over the life of the modified debt.

Extensions and Renewals: Simple loan extensions (like extending a bridge loan maturity by 6 months) may not trigger a significant modification if the extension was already provided for in the original loan documents, or if it does not exceed the thresholds above.

Schedule a consultation with Clearhouse Lending to discuss your loan modification options.

How Do Depreciation and Loan Structure Interact for Tax Purposes?

Depreciation is technically a property-level deduction rather than a loan-level one, but your loan structure directly affects how much depreciation you can claim and when.

Basis Includes Debt-Financed Portions: Your depreciable basis in commercial property includes the full purchase price (minus land value), regardless of how much you borrowed. A $5 million building purchased with $1.25 million down and a $3.75 million permanent loan gives you the same $5 million depreciable basis (less land) as an all-cash purchase.

Cost Segregation and Financing: Cost segregation studies, which reclassify building components into shorter depreciation categories (5, 7, or 15 years instead of 39), work the same regardless of loan type. However, the accelerated depreciation from cost segregation paired with interest deductions from the loan can create significant paper losses that offset other income.

Bonus Depreciation Phase-Down: For properties placed in service in 2026, bonus depreciation is 20% (down from 100% in 2022). This means a smaller portion of cost-segregated assets can be immediately expensed, making the choice between capitalizing construction interest (adding to basis) versus current deduction more nuanced.

Refinance and Basis: A cash-out refinance does not change your depreciable basis. If you purchased a property for $3 million and later refinance based on a $5 million appraised value, your depreciable basis remains $3 million. The additional loan proceeds are tax-free, but they do not create additional depreciation.

For a comprehensive overview of commercial property tax deductions, review our tax deductions for commercial real estate guide.

What Are the Key Tax Differences Between Loan Types at a Glance?

The table below consolidates the core tax differences across every major commercial loan type. Use it as a quick reference when evaluating financing options.

Choosing the right loan structure can significantly affect your annual tax position. Use our DSCR calculator to evaluate property-level cash flow, then consult your CPA to model the tax impact of each financing option.

Contact Clearhouse Lending for a free consultation on the best loan structure for your tax situation.

Frequently Asked Questions About Commercial Loan Tax Implications?

Can I deduct interest on a commercial bridge loan? Yes. Interest on a bridge loan used for an income-producing commercial property is fully deductible in the year paid. The only exception is when bridge loan funds are used for construction or substantial renovation of property not yet placed in service, in which case interest must be capitalized under IRC Section 263A.

Are refinance proceeds from a commercial property taxable? No. Loan proceeds from a commercial refinance are not taxable income because they create a corresponding debt obligation. This makes refinancing a powerful strategy for accessing equity without triggering capital gains tax. You still deduct the interest on the new loan as a business expense.

How long do I amortize SBA loan guarantee fees for tax purposes? SBA guarantee fees are amortized over the full term of the loan. For a 25-year SBA 504 loan, the guarantee fee deduction is spread across all 25 years. If you prepay the loan early, you can deduct the remaining unamortized portion in the year of prepayment.

Does a loan modification trigger a taxable event? It depends on whether the modification is "significant" under Treasury Regulation 1.1001-3. Changes to interest rate, payment timing, borrower, collateral, or loan type that exceed specified thresholds are treated as a deemed exchange of old debt for new debt, which can trigger deduction of unamortized costs and potentially cancellation of debt income.

What is the difference between recourse and non-recourse debt for tax deductions? Both allow interest deductions. The key difference is in loss deduction limits and partnership debt allocation. Recourse debt is allocated to the guaranteeing partner for basis purposes, while non-recourse debt from qualified lenders is shared among all partners. This affects how much loss each partner can deduct on their personal return.

Can I deduct construction loan interest in the year I pay it? Generally, no. Under IRC Section 263A (UNICAP), interest on construction loans must be capitalized into the property's cost basis during the production period. You recover the capitalized interest through depreciation deductions over 27.5 years (residential) or 39 years (commercial) once the property is placed in service.

Are points paid on a commercial loan deductible at closing? Unlike residential mortgages, points paid on commercial loans cannot be deducted in full at closing. They must be amortized over the life of the loan. If you pay 1.5 points ($15,000) on a $1 million, 10-year commercial loan, you deduct $1,500 per year for 10 years.

How does a cash-out refinance affect my depreciation deductions? It does not. A cash-out refinance does not change your property's depreciable basis, which remains tied to the original purchase price plus capital improvements. The additional loan proceeds are tax-free, but they do not generate additional depreciation deductions.

Sources?

1. Internal Revenue Code Section 163: Deduction for interest expense on trade or business debt. IRC Section 163
2. Internal Revenue Code Section 263A: Uniform capitalization rules for construction period interest. IRC Section 263A
3. Treasury Regulation 1.1001-3: Rules for determining when a debt modification is treated as a taxable exchange. Treas. Reg. 1.1001-3
4. IRS Publication 535 (Business Expenses): Guidance on deducting business interest and loan-related expenses. IRS Publication 535
5. IRS Publication 551 (Basis of Assets): Rules for determining cost basis, including capitalized interest. IRS Publication 551