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Am I allowed to dedcut mortgage interest on a loan while the realted house ( was a rental proeprty before rebuilding) is torn down and is under construction? - You can only deduct mortgage interest on a home that is not an investment property (i.e. rented out) and is used for personal use.The debt must be secured by the home as well. If the home is an investment property no mortgage interest deduction is allowed, instead the deduction is reported on Schedule E as interest expense.
Or am I required to capitalize it as part of construction cost? Yes this would be capitalized if you are to rent out the property.
If you are rebuilding to make the home your principal residence then yes, the amount would be allowed as mortgage interest dedction. If you don't have the intent(nor do you make it) your principal residence then the interest would be capitalized into the cost of the property for the peiod while under construction. The remainder of the interest would be reported as interest expense on Schedule E, assuming you make the property a rental.
Here is the IRS publication on the Mortgage Interest Deduction -
IRS Publication - http://www.irs.gov/pub/irs-pdf/p936.pdf
Please let me know if you have any further questions.
Thank you for your valuable opinion. I traced it to IRS Pub 936 page 4 for Home under construction.
Also, I found Capitalization Rule under Sec 263A(f). It seems to me that Pub 936 & Sec 263A(f) are contrary to each other for loan more than $1.5 with over 1 year of construction. would you please help with my puzzle. Thanks