Your contractor tells you construction loan interest is "definitely deductible." Your neighbor who just built a house agrees. Even your banker mentions it as a tax benefit when pitching the loan.

They're all partially right, and that's the problem.

Construction loan interest deductibility isn't a simple yes or no answer. The rules change completely depending on whether you're building a personal residence or investment property. Miss these distinctions, and you'll either overpay on taxes or face problems with the IRS later.

Many business owners assume construction interest works like regular mortgage interest: pay it, deduct it, save money. This assumption costs thousands of dollars every year because the real rules are more complex and opportunity-rich than many people realize.

The Reality Check: When Construction Interest Actually Counts

Whether construction loan interest saves you money depends on three key factors: how the property will be used, how long construction takes, and when interest begins.

• Personal residences: Interest can qualify as mortgage interest, but only during a 24-month window while construction is underway — and only if the finished property becomes your main or second home.

• Business and investment properties: Interest is usually capitalized, meaning it’s added to the property’s cost basis and recovered slowly through depreciation rather than deducted right away.

• Land-only loans: Interest isn’t deductible until you actually break ground.

The distinctions matter. Treated correctly, construction loan interest can reduce taxes in meaningful ways. Treated incorrectly, it can create disallowed deductions or missed opportunities.

Personal Residence: The 24-Month Rule Everyone Gets Wrong

If you're building a home for personal use, the IRS allows construction loan interest as a mortgage interest deduction, but with strict conditions.

What Must Be True for the Deduction

Your construction loan interest qualifies as deductible mortgage interest only when:

• The property becomes your main or second home once construction is finished

• Actual construction has begun (interest on bare land loans doesn’t count)

• The loan is secured by the property under construction

• You’re within the 24-month qualified residence window

• You itemize deductions on your return

The 24-Month Trap

IRS Publication 936, allows you to treat a home under construction as a “qualified residence” for up to 24 months. The window starts once construction begins — but it cannot extend past two years.

The risk: if construction takes longer, any interest paid outside that 24-month period is nondeductible. The IRS doesn’t make exceptions for weather delays, contractor disputes, or permit issues.

Example: Sarah’s custom home took 28 months to finish because of supply chain delays. She lost four months of interest deductions — about $8,000 in missed tax savings — simply because the build went past the 24-month limit.

Mortgage Debt Limits Still Apply

Even inside the 24-month window, interest deductions are capped by the overall mortgage interest rules:

• $750,000 limit for loans originated after December 15, 2017 (permanent under the OBBBA Act of 2025)

• $1 million limit for loans taken before that date

• Limits apply to total acquisition debt across all homes

Example: If you take out an $800,000 construction loan in 2025, only the first $750,000 of that debt qualifies for deductible interest. The rest produces no tax benefit.

Land Loans: No Deduction Until You Break Ground

Buying land with plans to build later doesn’t start the deduction clock. Interest on land loans isn’t deductible until actual construction begins.

Example: Buy land in 2023, but don’t start building until 2025? The interest you paid in 2023–2024 produces no deduction at all.

Business and Investment Properties: The Capitalization Reality

When you're building rental property, commercial space, or any other business property, construction loan interest follows completely different rules than personal residences..

Interest Gets Capitalized, Not Deducted

For business and investment construction projects, you typically cannot deduct interest payments as they happen. Instead, Section 263A of the tax code requires you to "capitalize" this interest: add it to the property's cost basis.

Example: Alex builds a $500,000 office building for his consulting business. He pays $30,000 in construction loan interest during the two-year build. Instead of deducting that $30,000 immediately, it gets added to the building's basis, making it worth $530,000 for tax purposes. Alex then depreciates this $530,000 over 39 years (the standard period for commercial real estate), recovering the capitalized interest slowly through depreciation deductions rather than getting immediate tax relief.

When Capitalization Rules Apply

You must generally capitalize construction loan interest when:

• Building rental or investment property (including residential rentals)

• Constructing business facilities you'll use in your trade or business

• Developing property for sale (real estate developers)

• The property isn't yet "placed in service" for its intended use

Note that for rental properties, additional rules regarding passive vs. active income may affect how and when you can use these deductions. Even if interest is capitalized into the property’s basis, passive activity loss rules can further limit when those tax benefits are realized. These passive activity limits often mean losses are deferred until you have passive income or dispose of the property.

The Exception: Property in Service

Once construction is complete and the property is placed in service (rented out, used in business, etc.), ongoing interest on permanent financing typically becomes deductible as a business expense. This timing difference matters for cash flow planning: during construction, interest payments provide no immediate tax relief, but after construction, they can reduce taxable income directly.

Small Business Exception Worth Knowing

There's one major exception to the capitalization rules that many business owners miss. If your business has average annual gross receipts of $29 million or less (this threshold is inflation-adjusted annually), you may qualify for the "small business exception" under Section 263A(i).

This exception allows qualifying small businesses to immediately deduct many costs that would otherwise need to be capitalized, including construction interest. For businesses building their own facilities, this can provide significant upfront tax savings instead of waiting decades for depreciation.

Example: A construction firm with $20 million in average receipts that builds its own warehouse could deduct its loan interest immediately. A developer with $40 million in receipts would not qualify and must capitalize.

If you qualify for the small business exception, keep in mind that whether you’re on cash or accrual accounting can affect the timing of when you claim interest deductions.

Common Misconceptions That Cost Money

A lot of homeowners and business owners hear half-truths about construction interest. Here are the biggest traps:

• Myth: “All construction interest is deductible.”
  Reality: For personal residences, deductions only apply during the 24-month qualified window. For business or rental property, most interest must be capitalized and recovered over time.
  
  

• Myth: “Home equity loans for construction are always deductible.”
  Reality: Since 2018, home equity interest is deductible only if the loan is used to buy, build, or substantially improve the home that secures the loan. Use it for other purposes — even business expenses — and it doesn’t qualify.
  Example: Jennifer used a home equity line for both a $40,000 kitchen renovation and $60,000 of dental practice equipment. Only the kitchen portion qualified as deductible mortgage interest.
  
  

• Myth: “Documentation isn’t that important.”
  Reality: The IRS requires strict tracing of loan proceeds. Sloppy records can knock out otherwise valid deductions.
  Example: If you borrow $200,000 but use $20,000 for personal expenses, only the portion tied directly to construction qualifies for favorable treatment.

Quick Recap: Home vs. Business Rules

• Personal residences: Construction loan interest may be deductible as mortgage interest — but only during the 24-month construction window, and only if the property becomes your home.

• Business and rental properties: Construction loan interest is usually capitalized into the property’s cost and recovered through depreciation, not deducted immediately.

• Land loans: No deduction until actual construction begins.

• Small businesses: If average annual gross receipts are $29 million or less (inflation-adjusted), you may qualify to deduct construction interest right away under the small business exception.

Construction Loan Interest: At-a-Glance

Strategic Planning Opportunities

Understanding these rules opens up tax-saving strategies that many business owners never consider.

Timing Construction Strategically

• Personal residences: You control when the 24-month deduction window starts. If you know construction will only take 16–18 months, starting the “clock” strategically can maximize your interest deductions.

• Business properties: Since interest is capitalized, consider whether beginning construction in a higher-income year makes sense — depreciation deductions in future years may be more valuable when they offset peak earnings.

Entity Structure Decisions

How you hold property can change how costs flow through your return. While the depreciation schedule is fixed by property type, your choice of entity affects how capitalized interest and depreciation flow through to your personal return — which can matter for cash flow and planning.

Mixed-Use Property Planning

If you’re building something that will serve both personal and business purposes — like a building with a ground-floor office and an upstairs apartment — you’ll need to allocate interest between the personal and business portions. The IRS expects a reasonable and well-documented method, usually based on square footage, cost, or use.

Documentation That Pays Off

The IRS won’t accept vague statements about how loan funds were used. You’ll need:

• Loan agreements and closing docs

• Contractor contracts and change orders

• Cancelled checks or wire confirmations tracing funds

• A construction timeline showing when work started and finished

• Occupancy certificates or placed-in-service records

Pro tip: If you use loan proceeds for mixed purposes, be precise. Borrow $200,000 but use $20,000 to pay credit cards? Only the $180,000 tied to the construction qualifies. The IRS requires dollar-for-dollar tracing.

What This Means for Your Tax Strategy

The table above shows just how different the rules are depending on property type. Here’s how to put that knowledge into action:

• If you’re building a personal residence:
  
  

  • Map your construction timeline carefully to maximize the 24-month deduction window.

  • Track all loan documents and contractor payments.

  • Watch your total acquisition debt — the $750,000 cap is now permanent under the 2025 OBBBA Act.
    
    

• If you’re building business or rental property:
  
  

  • Plan for the cash flow impact — interest won’t provide immediate relief while the property is under construction.

  • Check whether you qualify for the small business exception (≤ $29M in inflation-adjusted receipts). This can mean deducting interest immediately instead of capitalizing.

  • Factor in passive activity loss limits for rental properties — they may delay when you can use the deductions.
    
    

• If your project blends personal and business use:
  
  

  • Allocate interest between the personal portion (potentially deductible as mortgage interest) and the business portion (capitalized).

  • Keep allocation methods (square footage, cost, or usage) reasonable and well-documented.

Bottom line: The tax treatment of construction loan interest isn’t one-size-fits-all. With some upfront planning — and the right documentation — you can capture deductions that might otherwise slip away.

Making These Rules Work for You

Construction loan interest rules aren’t just theory — they directly shape how much tax you pay and when. For SMB owners and investors, the difference between getting it right and getting it wrong can be worth thousands per project.

• Miss the 24-month window on a personal build? You lose deductions permanently.

• Capitalize business interest without checking the small business exception? You give up immediate write-offs you might qualify for.

• Skip documentation or mix funds? You risk the IRS disallowing deductions entirely.

These aren’t details most tax software — or even many busy CPAs — will optimize for you.

That’s where we come in. At Town, our CPAs specialize in construction and real estate tax planning — helping business owners, builders, and investors structure projects so every dollar of eligible interest works as hard as possible. Whether you’re planning your first ground-up build or breaking ground on your next commercial project, we’ll make sure the tax rules work for you, not against you.

Disclaimer: This content is for educational purposes only and isn’t personalized tax advice. Tax laws change frequently, and the right approach depends on your specific circumstances. Talk with a qualified tax professional before making decisions about construction loan interest or related strategies.