Case — Qualified Residence Interest

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TL Case Summ

THE QUESTION

What is the definition of “under construction” for purposes of deducting mortgage interest?

THE DISPUTE

Taxpayer Says: Though the home was never built, work on the property was part of the construction process. The interest is deductible as qualified residence interest.

Internal Revenue Service Says: “Under construction” means the actual physical building process has begun. Mere site work does not qualify. The interest is not deductible as qualified residence interest.

THE LAW

From Internal Revenue Code Section 163(a): Allows a deduction for all interest paid or accrued within the taxable year on indebtedness.

From Internal Revenue Code Section 163(h): Provides that, in the case of a taxpayer other than a corporation, no deduction is allowed for personal interest. However, qualified residence interest is excluded from the definition of personal interest and thus is deductible under section 163(a) (see section 163(h)(2)(D)). Qualified residence interest is any interest that is paid or accrued during the taxable year on acquisition indebtedness or home equity indebtedness (see section 163(h)(3)(A)). Acquisition indebtedness is any indebtedness secured by the qualified residence of the taxpayer and incurred in acquiring, constructing, or substantially improving the qualified residence (see section 163(h)(3)(B)).

From Temporary Federal Tax Regulation 1.163-10T(p)(5): A taxpayer may treat a residence that is “under construction” as a qualified residence for a period of up to 24 months if the residence becomes a qualified residence as of the time that the residence is ready for occupancy.

THE CAUSE OF THE DISPUTE

When you itemize, you can claim a federal income tax deduction for the interest you pay on your principal residence and one other residence. The deduction is limited to amounts of up to $1.1 million that you take out to buy, build or improve your home, and your home must be used as security for the loan. When you build, the new home is considered a qualified residence for up to 24 months from the date construction starts, meaning you can deduct interest paid during that time.

Disputes arise because “under construction” is not defined in the tax code.

In this case, the taxpayers purchased a beachfront lot with an existing house. They planned to demolish the house (which they did) and build a vacation home. They took out a loan secured by the vacant lot, began working with various construction professionals to draw up designs and prepare the lot for the new home, and started the permitting process required for beachfront property.

Two years after buying the property, the taxpayers attempted, and failed, to get another loan to build the new home. They sold the property at a loss, and deducted the mortgage interest they’d paid over the two years it took to apply for permits, do preparatory measurements, survey the property, draw plans, demolish the existing house and clear the site. Though the new home was never built, they believed those activities met the definition of “under construction.”

The IRS says “under construction” means the physical building process has begun, and activities undertaken before that point are not construction. Since no construction was started (and no home ever actually built), there was no qualified residence, and the interest is not deductible. Additionally, the IRS says that because the property was sold before a new home was built, the taxpayers failed to satisfy the requirement that the property must become a qualified residence as of the time the residence is “ready for occupancy”, per the temporary regulation.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 26KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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For the taxpayer. Taxpayers undertook significant work in preparing to obtain a construction permit, and that work was a necessary component of the overall process of construction. The property was “under construction” as a residence during the two years in question. In regard to the sale of the property before a new residence was constructed, the deductions should be evaluated on the basis of facts and circumstances existing in the years in question. Events beyond the taxpayers’ control occurred in subsequent years and prevented them from completing a residence. Taxpayers are entitled to the claimed mortgage interest deductions.
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