15.4 Home Construction Loans

Interest on a home construction loan may be fully deductible for a period of up to 24 months while the home is under construction. Fot the 24-month period starting with the commencement of construction, the loan is considered acquisition debt subject to the $1 million ceiling (15.2), provided that the loan is secured by the lot on which construction is taking place and the home is a principal residence or second home when it is actually ready for occupancy. In one case, the Tax Court allowed an intrerest deduction under the 24-month construction period rule even though the home was never built; see Example 4 below.

According to the IRS, if construction begins before a loan is obtained, the loan is treated as acquisition debt to the extent of construction expenses within the 24-month period before the date of the loan. In determining the date of the loan for purposes of this 24-month rule, you can treat the date of a written loan application as the loan date, provided you receive the loan proceeds within 30 days after loan approval.

Interest incurred on the loan before construction begins is treated as nondeductible personal interest (see Example 1 in this section). If construction lasts more than 24 months, interest after the 24-month period also is treated as nondeductible personal interest.

Interest on loans taken out within 90 days after construction is completed may qualify for a full deduction. The loan is treated as acquisition debt to the extent of construction expenses within the last 24 months before the residence was completed, plus expenses through the date of the loan (see Example 2 below). For purposes of the 90-day rule, the loan proceeds generally are treated as received on the loan closing date. However, the date of a written loan application is treated as the loan date if the loan proceeds are actually received within 30 days after loan approval. If a loan application is made within the 90-day period and it is rejected, and a new application with another lender is made within a reasonable time after the rejection, a loan from the second lender will be considered timely even if more than 90 days have passed since the end of construction.

EXAMPLES
1. On October 14, 2011, you borrow $100,000 to buy a residential lot. The loan is secured by the lot. You begin construction of a principal residence on January 1, 2012, and use $250,000 of your own funds for construction expenses. The residence is completed December 31, 2013.
The interest paid in 2011 is nondeductible personal interest. It was paid before the 24-month qualifying construction period that started January 1, 2012, and ended December 31, 2013.
Interest paid in 2012 and 2013 is fully deductible as the $100,000 loan is treated as acquisition debt for the 24-month construction period.
2. Same facts as in Example 1, but on March 12, 2014, you take out a $300,000 mortgage on the completed house to raise funds. You use $100,000 of the loan proceeds to pay off the $100,000 loan on the lot and keep the balance.
All of the interest on the $300,000 loan is fully deductible because the loan qualifies as acquisition debt; $100,000 of the debt is treated as acquisition debt used for construction, since it was used to refinance the original 2011 debt to purchase the lot. The $200,000 balance is also treated as a construction loan under the 90-day rule. It was borrowed within 90 days after the residence was completed (December 31, 2013), and it reimbursed construction expenses of at least $200,000 incurred within 24 months before the completion date.
3. On January 11, 2012, you purchased a residential lot and began building a home on the lot using $45,000 of your personal funds. The home was completed on October 31, 2012. On November 20, 2012, you took out a loan of $36,000 that was secured by the home. The debt may be treated as taken out to build the home as it was taken out no later than 90 days after the home was completed, and expenditures of at least $36,000 were made within the period of 24 months before the home was completed.
4. Rose and his wife took out a $1.2 million loan and in March 2006 bought beach-front property in Fort Myers, Florida. The loan was secured by the property. They tore down the existing home, intending to build a new vacation home on the site. However, they needed a construction permit from the Florida Department of Environmental Protection and to get it, they had to submit plans, surveys and drilling samples in order to show that their proposed home would meet hurricane and flood standards and not harm turtle habitats. They finally obtained their construction permit in February 2008, but by that time the Florida real estate market was in decline, and they could not get financing to start building. In June 2009 they sold the property at a loss of $825,000.
The Roses claimed that their mortgage interest payments in 2006 and 2007 were deductible under the 24-month construction period rule. They argued that their demolition of the old house, clearing the site and their preparatory work for the intended home in surveying and drawing up plans as part of the permit process should be treated as “construction”. The IRS countered that there was no construction since the physical building process never began.
The Tax Court allowed the deductions. The demolition and site clearing work, as well as the planning and preparatory work as part of the permit process, were necessary components of the overall process of construction. The deductions are not barred by the fact that the Roses sold the property before completing a residence that was ready for occupancy. The IRS regulation does not specifically address the situation where the residence under construction never becomes ready for occupancy. Each tax year must stand on its own and as things stood in 2006 and 2007, it was impossible for the Roses to know that they would be unable to complete their planned residence because of events beyond their control.
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