Tax Write-Offs When Building a New Home

Capitalizing Home Construction

The reason you must capitalize your costs is because the IRS treats your new home, even before construction is complete, as a capital asset. Capital assets are subject to different tax rules that require you to keep track of every cost you incur to build the home rather than immediately writing them off. This includes the cost of purchasing land, fees you pay to contractors, the cost of applying for government building permits, closing costs on a mortgage you take out to build the home and all materials, equipment and appliances that are necessary.

When you capitalize your home construction costs, you are also calculating the home's tax basis. All eligible costs that you incur increase your tax basis in the home. The tax basis represents your total investment in the home and is subject to increase for home improvements you make after construction is complete. For example, if your initial investment in the home is $500,000 and five years later you decide to hire a contractor for $50,000 to build an addition, your new tax basis is $550,000. Tax basis is important because you only pay tax on the sale proceeds in excess of the basis if you ever sell the home.

You never recognize the tax benefit of capitalizing your home constructions until you sell the home. Once you agree on a price with a buyer, you simply reduce the sales price by your total tax basis to arrive at your capital gain. However, the purchase price will include any mortgage debt the buyer assumes, as well as outstanding real estate taxes he agrees to be responsible for. And if you own the home for more than one year after the start of construction, your gain is long-term, meaning that any taxable capital gains are subject to lower rates of tax than those that apply to your other types of income.

Owning the home for more than one year is especially important when it's not your main residence. This is because the IRS allows taxpayers to exclude some of their gains from taxes when they sell their main homes. To qualify, you must live in and own the home for at least two years during the five-year period that ends on the date of sale. At the time of publication, single taxpayers can exclude up to $250,000 of the gain, whereas, married taxpayers can exclude up to $500,000. However, if you file a joint return, both spouses must separately satisfy the two-year residency requirement, though only one spouse must satisfy the ownership requirement.