Is Interest on a Construction Loan Tax Deductible? A Guide for Homeowners

Taking on a construction project to build your dream home can be an exciting yet daunting process. One of the biggest financial considerations is securing financing to fund the construction. Many homeowners opt for a construction loan which provides periodic payouts to the builder as the project progresses.

If you have a construction loan, you may be wondering if the interest payments are tax deductible. The answer is “maybe” – it depends on meeting IRS requirements. Keep reading to learn more about deducting interest on a construction loan.

Overview of Construction Loan Interest Deductions

In general home mortgage interest payments are tax deductible on loans up to $750000. This includes interest paid on construction loans used to build a new home.

However, there are limitations:

• The home must become your primary residence once construction is complete.

• Construction must be completed within 24 months of taking out the loan.

• You must start occupying the home as your primary residence within a reasonable time after construction finishes.

As long as you meet these requirements, you can deduct mortgage interest payments made during the construction period on your tax return.

Deducting Construction Loan Interest Before Completion

Many homeowners wonder if they can deduct interest before construction is finished. The answer is yes – the IRS allows you to treat a home under construction as a qualified residence for up to 24 months.

This means you can deduct interest payments made during the construction phase, even though you aren’t living in the home yet.

For example, if construction takes 18 months, you would be able to deduct the interest for those 18 months. You do not have to wait until the home is completed to take the deduction.

What Happens After 24 Months?

You may only treat a home under construction as a qualified residence for 24 months maximum.

If construction takes longer than 24 months, any interest paid after the 24-month cut-off would not qualify for the mortgage interest deduction.

For example, if construction takes 30 months, the interest for months 25-30 would not be deductible. Only the interest for the first 24 months could be deducted.

Impact on Mortgage Limits

The standard mortgage limit for deductible interest is $750,000. With a construction loan, this limit applies to the principal balance after construction is complete.

This means you can borrow more than $750,000 during the construction phase. But once the home is finished, you must bring the balance down to $750,000 or less.

For example, you might borrow $1 million for construction. As long as the balance drops to $750,000 (or less) by the project’s completion, the interest would be deductible.

Points and Other Loan Fees

In addition to interest, certain other construction loan costs are deductible, such as:

• Points – Fees paid to reduce the interest rate are generally deductible in the year they are paid.

• Loan origination fees – Fees charged by the lender to initiate the loan are deductible over the life of the loan.

• Appraisal and credit report fees – Fees for services required by the lender can be deducted over the loan term.

Any costs that would apply when getting a standard mortgage (not just for construction) can also be deducted with a construction loan.

Recapture of Deductions

If you claim deductions for construction loan interest, but the home does not become your primary residence, you may have to “recapture” the deductions.

This means paying back the tax savings you received from the deductions. Recapture occurs if:

• You sell the home before living in it for at least 2 years.

• You convert the home to business or rental property use.

• Construction is abandoned (and you do not purchase another primary residence within 2 years).

In these cases, you would need to repay the recaptured amount when you file your tax return for the year these events occur.

Working With Your Tax Professional

Deducting construction loan interest can get complicated, especially if construction goes beyond 24 months or deductions are subject to recapture.

To ensure you maximize deductions legally and avoid recapture taxes, it is wise to work with a tax professional familiar with construction financing.

They can help you plan deductions, account for changes during the build process, and ensure all requirements are met. With the right guidance, you can deduct applicable interest while staying compliant.

Claiming the Mortgage Interest Deduction

To claim your construction loan interest deduction, you will need to file Form 1040 Schedule A with your individual tax return. The interest gets reported in the section for itemized deductions for home mortgage interest paid.

Be sure to keep detailed records showing:

• Construction loan interest paid each year
• Loan origination and appraisal fees
• Points paid on the construction loan

Work with your lender to get an annual statement documenting interest and fees paid. Keep all invoices and receipts related to the loan as well.

Thorough documentation will help support the deductions if your return is ever audited.

The Bottom Line

Building a custom home is a major investment. Taking advantage of tax deductions available on construction loans helps offset some of the financial impact.

As long as your new home becomes your primary residence for at least 2 years, you can deduct interest paid during the building phase. Work closely with your CPA to maximize write-offs and avoid recapture of deductions.

With the right tax planning, you can make your construction project more affordable and reduce costs through substantial tax savings. Careful tracking of interest and fees ensures you claim all eligible deductions when filing your return.