The Internal Revenue Service has one set of rules governing the deduction of construction interest on residential property you occupy and a different set of rules for construction interest on rental properties. Although the IRS generally disallows deduction of interest during the construction period, it does allow you to depreciate construction-related interest paid on commercial projects. It also allows you to deduct some interest paid on residential construction as long as you occupy the building immediately after it's completed.
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The IRS rules governing deduction of interest on commercial construction are a little tricky. If you're constructing a building that you intend to rent out -- an apartment complex, for instance -- you will normally secure financing prior before beginning construction for such things as permits, surveys, soil reports and architectural and engineering fees. The IRS treats interest that accrues on the money you draw from the construction loan until actual construction begins as a current business expense that is fully deductible against income in the tax year the interest is paid. Once construction begins, it is not deductible. This includes both the interest on amounts drawn before construction and amounts drawn during construction. Once construction ends, all further interest payments become fully deductible as a current business expense.
Depreciation Rules on Rental Property Construction
Although you can't deduct interest paid on construction of commercial projects during the actual construction period, the IRS does allow you to add mortgage interest to the cost basis of residential rental property and to depreciate it over the allowed depreciation period. For property placed in service after 1986, which is subject to the Modified Accelerated Cost Recovery System, or MACRS, this is normally 27.5 years. The detailed calculation of MACRS depreciation in some circumstances -- such as the year of acquisition and the year of sale -- can become complicated, so you might want to get advice from a certified public accountant.
Interest Payments on Residential Construction
The IRS allows residential property owners to deduct interest paid during the period of occupancy, subject to the $1 million mortgage limit. The IRS requires you to prorate interest deductions on mortgages larger than $1 million. For example, you can deduct only half the interest on a $2 million mortgage. In all cases, you take this as an itemized deduction on your Schedule A. With one exception, the IRS does not allow you to deduct interest paid on residential construction loans. If you move in, however, on the day construction is completed and the house can be occupied, you can deduct all interest paid during the preceding two years of the construction loan period.
Interest on Construction of Second Homes
Interest paid on debt for construction or purchase of second homes is subject to the same rules as interest paid on your primary residence. The deduction limits are cumulative, however. If you have a $600,000 mortgage on your primary residence and a $500,000 mortgage on your second home, the interest on only $1 million of the $1.1 million mortgage debt is deductible.