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

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 beginning of construction of the residence as short as possible. Obviously, thee taxpayer should plan to complete the residence before the 24-month period expires, thus insuring the deductibility of the interest expense as qualified residence interest expense.

Example: Taxpayer T purchases raw land through a mortgage secured by the land and any property to be constructed thereon on Sept. 20, 1991. T starts construction on the residence on Jan. 20, 1992. The proceeds from the mortgage are directly traceable to the completion of the residence, which is ready for occupancy on Apr. 20, 1994.

The interest expense incurred from Sept. 20, 1991 through Jan. 19, 1992 is nondeductible personal interest expense. The interest expense incurred from Jan. 20, 1992 through Jan. 20, 1994 could be qualified residence interest, fully deductible on T's Form 1040 Schedule A. The interest expense incurred from Jan. 21, 1994 through Apr. 20, 1994 would be nondeductible personal interest expense. The 24-month period may begin on or after the date construction is begun (Temp. Regs. Sex. 1.163-10T(p)(5)(ii), Example). Therefore, T may treat the 24-month period as beginning Apr. 21, 1992 and ending Apr. 20, 1994. In this case, the interest incurred from Sept. 20, 1991 through Apr. 20, 1992 would be nondeductible personal interest expense. If T has previously deducted the interest for that period, he must amend the 1991 and 1992 returns to reflect such interest as nondeductible personal interest.

Conclusion

When purchasing raw land with the intent of constructing a personal residence, the following should be considered.

* The time period between the purchase of the land and the commencement of construction of the residence should be as short as possible.

* The construction of the residence should take place within a 24-month period, if at all possible.

* When construction takes longer than 24 months, the 24-month window with the greatest interest expense should be chosen to maximize the qualified interest expense deduction.

* If the land is purchased for investment purposes, with the intent of constructing a ental unit, and the taxpayer later changes his mind (either duirng the construction phase or sometime prior to occupancy), this change should be sufficiently documented.

From Bart Forrest, CPA, Long Beach, Cal.
COPYRIGHT 1992 American Institute of CPA's
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Author:Forrest, Bart
Publication:The Tax Adviser
Date:Mar 1, 1992
Words:762
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