Put simply; construction interest expense is the cost of borrowing money to finance the building and development of a property.
This type of interest usually has an accelerated schedule (interest is accrued more often). It is only deductible if the property sells for more than the total amount owed on it. Interest incurred for acquiring a property will be amortized over 30 years, while interest incurred for refinancing a loan will be amortized over 20 years.
Interest expenses that are incurred by a business are generally tax deductible. Interest on construction loans is an ordinary and necessary business expense.
Construction interest is only deductible if the property sells for more than the total amount owed on it. If the property sells for less than what you owe, and that excess debt can be attributed to financing costs, you can deduct interest and even depreciation in that year.
If a taxpayer has financed real estate with debt, he or she may deduct ordinary losses from the rental activities of the real estate against other income. However, this deduction may not exceed net investment income or 30% of adjusted gross income (AGI), whichever is greater.
The IRS allows confident investors to deduct a portion of their interest expense by using the Modified Accelerated Cost Recovery System (MACRS) rules.
When real estate developers take out an improvement loan, they often allow their investors to make payments in quarterly installments at a rate of approximately 10% interest over the life of the loan.
The developer usually gets an idea of how much money he or she can borrow by selling additional units, and this number is based on what is expected at that time. The higher the price paid for a unit, through any means, the more debt financing a developer can take on.
Construction interest expense for a project will depend upon many factors, including the type and length of the loan, the resale price of the property and the creditworthiness of the borrower. Interest expenses can vary from very low-interest rates over time to high-interest rates.
Interest is usually limited to 30 years, but can go up to 40 or 50 years if there are significant cash flow requirements. As long as a taxpayer uses debt financing in conjunction with equity, he or she may deduct interest on a construction loan and may even amortize it over 30 years if no other deduction is available.
An illustration of real estate construction interest expense:
When a homeowner, for instance, takes out a construction loan to build a new home, he or she will accrue interest costs throughout the course of the time that the house is being constructed.
The accumulated interest is capitalised and included in the cost basis of the construction project after it is leased out and starts to create revenue for the owner, as an example.
An example of the taxability of debt financing is a building under construction with a $1 million loan on it. The interest cost is $200,000 over the 30-year life of the loan (10% x $1 million = $100,000).
Because this is an improvement, it will have to be depreciated. The yearly allowable depreciation is limited to approximately 20% until completion and then 100%, the remaining 60% being §226(a)(7) (as permitted under §1031) income.
The following are some examples and rules of construction interest expense.
In this example, the taxpayer is purchasing a property built on a 30-year loan at 6% interest. The interest cost is $66,000. By putting the costs into a table and using the percentage rate, it can be seen that $49,000 of the $66,000 is an annualized rate. Therefore, 75% would be an effective interest rate (the remaining 25%).
When a taxpayer borrows money for construction purposes, he or she may deduct interest paid on a construction loan on Schedule A (Form 1040) or in the same way as other interest paid.
If the amount of interest paid is less than $10,000 at any time during the tax year (or portion of it), then that interest is not deductible. Small amounts are generally not deducted because they are usually not allowed until after other expenses and deductions are taken into account.
If the construction loan is secured by real property, the taxpayer must determine whether to treat the debt as a deficiency or as an addition to his or her debt.
In general, an addition to the taxpayer's debt is made when the debt incurred to acquire or improve a property exceeds its depreciable basis of $1 million. When making this determination, make sure to apply the same rules that are used to determine whether depreciation is allowable.
Suppose the taxpayer uses debt financing from his or her pocket (i.e., does not secure the debt with real property), but adds a home office for his or her self-employment. In that case, there will be no addition to his or her debt and interest expenses can be deducted in that year as an expense.
How Does Construction Interest Expense Work?
No interest paid during construction on a building held for rental or commercial usage is deductible. To account for this interest, the asset's cost base is increased. Capitalized interest is another name for it because of this reason.
Interest that has been capitalized does not appear as a cost on the company's income statement, making it distinct from interest payments paid out of pocket.
Conclusion
Interest expense incurred while constructing or improving a building or other structure is tax deductible.
The interest payments must be made for the property's acquisition, construction, reconstruction, erection, installation, improvement, repair, or protection.
If you have further questions about what is construction interest expense and how to claim it on your taxes, ask away in the comment!
