Maximizing the interest expense deduction on a self-constructed residence.

• Author: Forrest, Bart

Sec. 163(h) disallows the deduction of personal interest except for qualified residence interest (as defined under Sec. 163(h)(3)). Qualified residence interest is limited to the interest on $1 million of acquisition indebtedness and $100,000 of home equity indebtedness. Acquisition indebtedness can include indebtedness incurred in constructing property. For example, a taxpayer may acquire raw land by obtaining a mortgage secured by the land and any property to be constructed thereon. If the dwelling unit is to be used as a residence, the interest expenses associated with holding the land prior to the commencement of construction is personal interest under Sec. 163(h). If, one the other hand, the dwelling unit is to be used as a rental property, the interest expense associted with the raw land will be treated as investment interest expense (Sec. 163(d)). Similarly, if the unimproved land itself is leased prior to commencing construction, interest expense will be investment interest.

Once a taxpayer begins construction of the residence the interest might be qualified residence interest. Under Temp. Regs. Sec. 1.163-10T(p)(5), a taxpayer may treat a residence under construction as a qualified residence for a period of up to 24 months prior to occupancy, if the dwelling becomes a residence when ready for occupancy; see also Notce 88-74. A qualified residence is defined as a taxpayer's principal residence or the taxpayer's second residence (Temp. Reg.s Sec. 1.163-10T(p)(1)). Thus, the taxpayer can deduct the interest expense incurred during the construction of the residence as qualified residence interest for a 24-month period (if it meets the definition of a qualified residence under Sec. 163(h)(4)). This assumes, of course, that the additional proceeds to construct the house are traceable to the loan obligation securing the house; the tracing rules of Temp. Regs. Sec. 1.163-8T apply in determining which proceeds are used in construction. Also, debt incurred no later than 90 days after construction is complete may be treated as acquisition indebtedness. unfortunately, if construction takes longer than 24 months, the interest expense incurred once the 24-month period has elapsed is treated as nondeductible personal interest (see Sec. 163(h)(2)).

Planning

To avoid the forfeiture of interest expense deductions on the self-construction of a personal residence, the taxpayer should keep the time period between the purchase of the land and the...