Wondering whether you can deduct the interest you pay on money you borrow to buy land and construct a building? The answer depends on what you use the building for—your home, or a business purpose such as an apartment building.
The home mortgage deduction is one of the most popular deductions. It permits you to deduct the interest on up to $750,000 you borrow to buy or build a new main home and/or second non-rental home so long as the loan is secured by the home (the limit is $1 million for homes purchased before 2018). This is an itemized personal deduction you take on IRS Schedule A.
Ordinarily, you have to live in the home to qualify for the home mortgage interest deduction. Obviously, you can't live in a home while it's being built. Fortunately, the tax law gives you a break here. So long as the home becomes your main home or second home on the day it's ready for occupancy, you can deduct all the interest you paid on the construction loan within 24 months before the home was completed.
If you borrow money to construct business property, such as an apartment building, you don't qualify for the home mortgage interest deduction. However, you may deduct as a business expense the interest you pay on the loan both before and after the construction period. But you may not deduct the interest you pay during the construction period. Instead, this cost must be added to the basis of your property and depreciated over 27.5 years (the depreciation period for residential rental property). (I.R.C. § 263A(f)(1).)
The construction period for real property begins when physical construction starts. Physical construction includes:
The construction period ends when all production activities reasonably expected to be done are completed and the property is placed in service—that is, made available for rent.
Activities such as planning and design, preparing architectural blueprints, or obtaining building permits do not constitute physical construction. Thus, interest paid while these activities are going on, but before physical construction is done, can be currently deducted as an operating expense.
Example: Jennifer obtains a $100,000 loan to construct a rental house. She gets the loan on January 15 and starts paying interest on February 1. Because of problems in obtaining final approval for a building permit, physical construction of the house does not begin until June 1. Jennifer may deduct the interest she paid during February through May. She cannot, however, deduct the interest she pays while the house is being constructed from May through October. Instead, she must add it to the tax basis of the house and depreciate it over 27.5 years. The interest Jennifer pays after the house is completed and offered for rent she can currently deduct as she pays it each year.
Nolo's Every Landlord's Tax Deduction Guide, by Stephen Fishman, provides complete details on tax and depreciation deductions for rental property owners, IRS rules on repairs and improvements, and much more.