Construction Loan Interest and the Vacant Land Tax Rules

When you build an investment property, the single largest cost in those early months is usually the interest on your loans. It runs while there is no tenant, no rent and no income from the property at all. Most investors assume that interest simply disappears into the project's cost base for a future capital gains tax calculation, until the day a tenant moves in.

It is not always that simple. How your construction loan interest is treated can change the after-tax cost of your build.

There is an important distinction in the tax law between the interest on the money you borrowed to hold the land and the interest on the money you borrowed to construct the building. The two are treated differently, and the difference rests on a specific Australian Taxation Office ruling, TR 2023/3, read together with a long-standing High Court principle. Getting the distinction right, and keeping the records to support it, can mean part of your construction interest is deductible in the year you incur it, rather than locked away in your cost base for years.

This article unpacks how the rules work, how the deduction is reported, how to stay compliant and where the traps sit. It is general information to help you ask your accountant the right questions. It is not advice, it is not a recommendation, and none of it should be acted on until your accountant has confirmed it against your own circumstances.

Since 1 July 2019, section 26-102 of the Income Tax Assessment Act 1997 has limited the deductions available for the cost of holding vacant land. The rule was introduced to stop taxpayers claiming large interest and holding-cost deductions on empty blocks that were not yet producing any income.

Broadly, where land has no substantial and permanent structure that is in use or available for use, the ordinary holding costs of that land are denied as deductions. That includes the interest on the loan used to acquire the land, along with council rates, land tax and similar costs. For residential premises being built on the land, the structure is not treated as in use or available for use until it can be lawfully occupied, which the ATO links to the issue of the occupancy certificate or equivalent council approval, and the property is leased or genuinely available for lease.

The ATO's view on all of this is set out in Taxation Ruling TR 2023/3, which finalised the Commissioner's position on section 26-102. So far this sounds like bad news for anyone building. While the block sits there mid-build, the land is vacant for these purposes, and the interest on the land loan is denied.

Here is the part that changes the picture. The vacant land rule applies to the cost of holding land. It does not apply to the cost of constructing a building on it.

TR 2023/3 is explicit. The Commissioner states that the costs of repairing, renovating or constructing a structure on land, and any interest or borrowing costs to the extent they are associated with that construction, are not treated as a loss or outgoing related to holding land. In other words, construction-loan interest falls outside section 26-102 altogether. The vacant land rule does not reach it.

The Ruling illustrates this directly. In Example 6, a taxpayer named Giovanna buys a vacant block intending to build a house to rent out. She takes one loan to buy the land and a separate loan for the construction. The Ruling concludes that she cannot deduct the interest on the land loan until the house is lawfully occupied and available for lease, but that section 26-102 will not stand in the way of deducting the construction-loan interest.

This is the point where the popular version of this strategy goes wrong, and where your accountant earns their fee.

Saying section 26-102 does not deny the construction interest is only half the test. The interest still has to be deductible in the first place under the general deduction provision, section 8-1 of the ITAA 1997. Look carefully at the wording in Example 6: the Ruling says that if a deduction is otherwise available for the construction-loan interest, section 26-102 will not prevent it. The words "otherwise available" are doing a great deal of work.

For the construction interest to be deductible under section 8-1, there has to be a genuine connection between that interest and the future earning of assessable rental income. This is governed by a principle established by the High Court in Steele v Deputy Commissioner of Taxation and explained by the ATO in Taxation Ruling TR 2004/4. The principle is that interest incurred before any income is earned can still be deductible, provided the taxpayer has a genuine and continuing intention to use the property to produce assessable income, the interest is not incurred too soon, is not merely preliminary to the income-earning activity, and is not separated from it by so long a gap that the connection is broken.

The contrast case is Temelli, where the taxpayers held land for years without a firm commitment to build. That delay left open the possibility that the land was being held for some other purpose, the necessary connection was broken, and the interest was not deductible.

So the construction interest is deductible only where you can demonstrate a real, committed, income-producing purpose: you are genuinely building to rent, you are actively progressing the build, and you can show it. An intention that is vague, stalled or contingent will not satisfy section 8-1, and the fact that section 26-102 does not separately deny the interest will not save it.

Putting the two rules together, a typical build with separate land and construction lending moves through three stages.

Stage	Land-loan interest	Construction-loan interest
During construction	Generally denied by section 26-102. The land is vacant until the dwelling can be lawfully occupied and is available for lease.	Sits outside section 26-102. Deductible if, and only if, it meets the section 8-1 income-producing test under the Steele principle.
Occupancy certificate issued, listed for lease	Becomes deductible from this date. The land is no longer vacant.	Continues to be deductible on ordinary principles.
Denied land interest, longer term	May form part of the third element of the cost base for CGT, which can reduce a future capital gain.	Already claimed in the year incurred, where the section 8-1 test was met.

The interest on the land loan that was denied during construction is not simply lost. Where section 26-102 prevents a deduction, the Ruling notes that those amounts may form part of the third element of the cost base of the asset under the capital gains tax rules. That can reduce a future capital gain, though it is worth understanding that the third element only helps where there is a capital gain on sale, not a loss. Your accountant will confirm how this applies to you.

To show why the construction phase matters, here are two simplified examples drawn from ASPIRE Property Investment Funding Analysis (PIFA) models. Each one isolates the interest on the construction loan itself, drawn down progressively across the building progress claims from site start through to practical completion. This is the construction-loan slice only; it is separate from the interest on the land loan, which is the larger figure that the vacant land rule denies during the build. The numbers are rounded and illustrative. They are not projections, not advice and not a guarantee, and your accountant must confirm what is deductible in your circumstances.

Note the pattern. The PIFA is itself part of the evidence trail. It documents a genuine, committed intention to build and rent, the build contract, the staged drawdown schedule and the timeline, which is exactly the kind of material that supports the income-producing purpose the law requires.

Side by side, the comparison makes the point at a glance.

Construction phase	QLD, faster build	WA, longer build
Building-contract cost (approx)	$467,000	$437,000
Construction loan rate (approx)	6.3%	5.5%
Construction period (approx)	163 days, about 5.5 months	365 days, about 12 months
Construction-loan interest, progressive drawdown (approx)	$5,800	$10,700

A simple comparison of the construction-loan interest in each example.

If you lodge your own return through myTax, rental deductions are entered after you indicate you had Australian income or losses from investments or property, and then complete the rental property section. Interest is claimed in the rental expenses field under the interest on loans category. The ATO stresses claiming each expense under the correct expense type so it is treated correctly.

In practice, almost anyone running this kind of build should be lodging through a registered tax agent. The apportionment between land and construction interest, the timing of when each becomes deductible, and the cost-base treatment of the denied amounts are exactly the kinds of details that benefit from a professional preparing the return.

Three things matter more than anything else here, and all three are about evidence.

Loan separation. The cleanest version of this strategy uses separate loans for the land and for construction, as in the Ruling's own example. Where a single loan funds both, the interest has to be apportioned between the land component and the construction component on a fair and reasonable basis, and that apportionment must be supportable. Mixing the two in one account makes the position far harder to defend.

Proof of income-producing intention. Because the construction interest only qualifies where there is a genuine and committed intention to rent, you want a clear evidence trail: your property investment strategy report, the build contract, the finance approval for construction, progress on site, and ultimately the listing of the property for lease. The more the timeline shows steady, committed progress toward a rental outcome, the stronger the position. Long, unexplained delays are the single biggest risk to the claim.

Record keeping. Keep your loan statements, builder invoices and construction drawdown records organised so you can tie each dollar of interest to either land or construction. The ATO has signalled increased scrutiny of rental claims generally, and the burden of proof sits with the taxpayer.

This is a good example of why strategy and structure should come before the purchase, not after. The investor who sets up separate land and construction lending from the outset, builds without undue delay and keeps clean records is in a position to treat the construction interest correctly and add the denied land interest to their cost base. The investor who funds everything through one account, lets the project drift and keeps loose records may lose the benefit of the distinction entirely, even though the underlying law was available to both.

The law here is settled and public. The difference in outcome comes down to how the arrangement is set up and documented, which is a planning decision made at the start.

The references below are the official Acts, rulings and case law behind this article. You must verify your own circumstances with your accountant or registered tax agent. Do not rely on this list as advice.

Legislation
Income Tax Assessment Act 1997, section 26-102 (vacant land) and section 8-1 (general deductions). legislation.gov.au
Australian Taxation Office rulings
Taxation Ruling TR 2023/3, Income tax: expenses associated with holding vacant land. ato.gov.au
Taxation Ruling TR 2004/4, Income tax: deductions for interest incurred before the commencement of, or following the cessation of, relevant income-earning activities. ato.gov.au
Case law and ATO guidance
Steele v Deputy Commissioner of Taxation (1999) 197 CLR 459. austlii.edu.au
Residential rental properties: rental expenses, capital expenses, and how to claim rental expenses. ato.gov.au