Interest Capitalization: A Simple Guide to Construction Costs
Interest capitalization means adding interest incurred while building or preparing a qualifying asset to that asset’s cost instead of expensing it. Under U.S. generally accepted accounting principles (GAAP, ASC 835-20), the amount is avoidable interest: the average amount invested in the project times the interest rate, capped at actual interest. It ends when the asset is ready for use.
This distinction matters because it changes when a cost affects income. Interest added to a building is generally recognized through depreciation over the building’s useful life. Interest expense reduces income in the current period.
Video lesson with Professor Farhat
In this 12-minute lesson, Professor Farhat works through a full interest capitalization example: weighted average accumulated expenditures, avoidable interest, actual interest, and the journal entry. Jump to 1:08 to start with the construction facts. The companion articles go deeper on multi-payment schedules and multiple loans.
Watch Professor Farhat’s interest capitalization example on YouTube.
What Is The Difference Between Capitalized Interest And Interest Expense?
“Capitalize” means record a cost in an asset account. It does not mean the lender forgives interest, the company avoids paying cash, or the loan balance automatically increases. The borrowing obligation and the accounting classification are separate questions.
| Question | Capitalized interest | Interest expense |
|---|---|---|
| Where is it recorded initially? | In the qualifying asset’s cost | In the current income statement |
| When does it affect income? | Generally through depreciation for a completed building | In the period incurred |
| Does the classification change cash owed? | No | No |
The purpose is to include eligible financing costs in the investment needed to prepare the asset. This extends the acquisition-cost principle discussed in our property, plant and equipment cost guide. Interest capitalization is required when the applicable effect is material; it is not a free choice to make current profit look higher.
Which assets qualify for interest capitalization?
A qualifying asset takes time to prepare for its intended use. Common examples are a warehouse built for the company, a large machine constructed for its production line, or a ship built as a discrete project for sale. Hiring an outside contractor does not by itself prevent capitalization.
| Situation | Result |
|---|---|
| Office building under active construction for the company | Potentially qualifies |
| Separate real estate project constructed for sale | Potentially qualifies |
| Equity-method investment in a company that is using the funds to build assets before starting its planned principal operations | Potentially qualifies |
| Purchased machine already ready to operate | No preparation period to capitalize |
| Vacant land held without development activity | Does not qualify while simply held |
| Goods routinely manufactured in large quantities, repeatedly | Do not qualify under this rule |
The Financial Accounting Standards Board (FASB) describes these categories in its historical Statement 34 summary. The current U.S. GAAP topic is Accounting Standards Codification (ASC) 835-20. Do not confuse “valuable asset” with “qualifying asset”: an expensive, ready-to-use machine still fails the preparation-period test.
When does the capitalization period start and end?
Interest capitalization starts only when all three conditions coexist: qualifying expenditures have been made, activities needed to prepare the asset are underway, and interest cost is being incurred. Check the facts in that order before applying a rate.
Borrowing money in January does not establish a January start if project spending begins in April. Conversely, necessary planning and technical preparation can count as activities; physical construction is not the only relevant work. If the company suspends substantially all work on the project, capitalization stops until work resumes. Brief interruptions, interruptions imposed by outside parties, and delays that are a normal part of the process do not stop capitalization.
The period ends when the asset is substantially complete and ready for its intended use. It does not continue until the loan is repaid, customers arrive, or management chooses an opening ceremony. FASB Statement 34, paragraphs 17–18, explains the origin of these timing principles; current requirements are organized in ASC 835-20.
Some projects are finished in parts that can each be used on their own, such as separate units in a condominium project. In that case, capitalization stops on each part when that part is ready. Interest on the parts still under construction keeps being capitalized while work on them continues.
How Do You Calculate Capitalized Interest? A Simple Example
Hypothetical example. Cedar Services borrows $600,000 at 6% on January 1. Necessary planning begins March 1. It pays $240,000 for construction on April 1, makes no other payments, and the building is ready on September 30. Assume the debt remains outstanding all year, no other debt exists, and the effect is material.
| Date | Event | Interest treatment |
|---|---|---|
| January 1 | Loan begins | Borrowing alone is insufficient |
| March 1 | Preparation begins | No qualifying expenditure yet |
| April 1 | $240,000 payment | All three conditions now exist |
| September 30 | Ready for intended use | Capitalization ends |
Avoidable interest is the interest the company would not have incurred if it had not spent money on the project. The formula is weighted average accumulated expenditures (WAAE) × interest rate. WAAE weights each payment by how long it was invested in the project during the capitalization period. Cedar’s single $240,000 payment was in the project for six months, so WAAE is $240,000 × 6/12 = $120,000. Avoidable interest is $120,000 × 6% = $7,200. Actual annual interest is $600,000 × 6% = $36,000. Capitalize $7,200 and expense the remaining $28,800. The building’s cost becomes $247,200. Capitalization changes the classification of the $36,000; it does not create another payment.
Journal Entry For Cedar Services
Here is the year-end entry, assuming Cedar pays the $36,000 of interest in cash:
| Account | Debit | Credit |
|---|---|---|
| Building | $7,200 | |
| Interest Expense | $28,800 | |
| Cash | $36,000 |
If the interest has not been paid yet, credit Interest Payable instead of Cash. During construction, the capitalized amount is often recorded in Construction in Progress and moved to Building when the asset is ready. Notice that the two debits add up to the $36,000 of actual interest.
Common mistakes to avoid
Do not capitalize all interest just because construction is underway. Do not start at the loan date without checking spending and preparation. Do not keep capitalizing after readiness because debt remains outstanding. Also distinguish land held idle from land actively being prepared as a building site; the latter can enter the eligible expenditure calculation.
One more trap: do not reduce capitalized interest by interest income earned on unused loan money. Cedar borrowed $600,000 but spent only $240,000. Under U.S. GAAP, any interest Cedar earns by investing the unspent $360,000 is generally reported separately and does not reduce the $7,200. A narrow exception applies to certain tax-exempt borrowings restricted to the project. IFRS treats this differently, as the comparison below shows.
A final check is to explain the result in words: some interest relates to preparing the asset and becomes part of its cost; the rest remains a period expense. If the explanation depends only on the size of the loan, revisit the expenditure schedule.
How Does Interest Capitalization Differ Under IFRS And Tax Rules?
The same idea shows up under international standards and in the tax code, with a few twists worth knowing.
| Point | U.S. GAAP (ASC 835-20) | IFRS (IAS 23) |
|---|---|---|
| What can be capitalized | Interest cost | Borrowing costs, which can also include certain foreign exchange differences on foreign currency loans |
| Interest earned on unspent loan money | Generally not deducted from capitalized interest | Deducted from capitalized borrowing costs on specific borrowings |
| Long pause in work | Capitalization stops if substantially all work is suspended | Capitalization is suspended during extended periods when active development stops |
For federal income tax, IRC §263A(f) has its own interest capitalization rule for what it calls designated property. That covers all real property a business produces, plus produced tangible personal property with a class life of 20 years or more, an estimated production period over two years, or an estimated production period over one year and a cost over $1,000,000. Businesses that meet the small business gross receipts test in IRC §448(c) are generally exempt from §263A. Because book and tax rules differ, the capitalized amounts can differ too, which can create a temporary difference for deferred taxes.
Key Takeaways
- Interest capitalization records eligible interest as part of a qualifying asset’s cost instead of as a current expense.
- Qualifying assets need a preparation period: assets built for your own use, discrete projects built for sale or lease, and certain equity-method investments.
- Capitalization starts only when spending, preparation work, and interest all exist, and it ends when the asset is substantially complete and ready for use.
- Capitalize the lower of avoidable interest (WAAE × interest rate) and actual interest incurred.
- Capitalized interest reaches the income statement later, mainly through depreciation.
- Companies disclose the total interest cost incurred during the period and the amount capitalized.
Want more practice like this? The Intermediate Accounting course covers interest capitalization alongside the rest of property, plant, and equipment, with video lessons and practice questions. If you’d like to see how Farhat Lectures works first, try the free sample course.
Interactive Exercise on Interest Capitalization
Under U.S. GAAP, eligible interest incurred while preparing a qualifying asset for use becomes part of the asset’s cost. Capitalization ends when the asset is substantially complete and ready for its intended use. Apply that cutoff to three CPA FAR questions about a warehouse construction loan.
Practice questions with explained answers
1. A company buys equipment that is ready to use immediately. Can it capitalize a year of loan interest?
Answer: No. A loan does not create a construction period. Interest incurred after readiness is generally expensed.
2. A loan begins January 1, qualifying work begins February 1, and the first payment is March 1. When can capitalization begin?
Answer: March 1, assuming interest is still being incurred. That is the first date when all three conditions coexist.
3. Eligible avoidable interest is $9,000 and actual interest is $12,500. What amounts are capitalized and expensed?
Answer: Capitalize $9,000 and expense $3,500. Use the lower amount, then reconcile the two classifications to actual interest.
Frequently asked questions
Is interest capitalization the same as compound interest?
No. This lesson concerns adding eligible interest to an asset’s accounting cost. Compound interest describes earning or charging interest on accumulated interest.
Can capitalization apply without a separate construction loan?
Yes. General borrowings can support eligible interest capitalization. The related calculation uses an appropriate weighted borrowing rate.
Does a building have to generate revenue before capitalization stops?
No. The relevant point is substantial completion and readiness for intended use, even if actual operation begins later.
Is This The Same As Interest Capitalization On A Student Loan?
No. On a student loan or other personal loan, capitalization means unpaid interest is added to the loan balance, so you then pay interest on a larger amount. In accounting for construction, capitalization means recording interest as part of an asset’s cost. The loan balance does not change.
What Happens To Capitalized Interest After The Asset Is Finished?
Capitalized interest remains part of the asset’s cost. For depreciable assets, it is recognized in expense over time through depreciation. For an asset built for sale, it becomes part of cost of goods sold when the asset is sold.
What Do Companies Disclose About Capitalized Interest?
They disclose the total interest cost incurred during the period and how much of that interest was capitalized.
Sources and lesson context
This original study guide follows Wiley Intermediate Accounting, section 9.2: Interest Costs During Construction. All examples and practice questions here are hypothetical and original. The current U.S. GAAP reference is FASB ASC 835-20, Capitalization of Interest. FASB Statement 34 provides accessible historical background; the Codification is the current authoritative source.
The IFRS comparison refers to IAS 23, Borrowing Costs. The tax rules come from IRC §263A(f) and Treasury Regulation §1.263A-8, and the IRS practice unit on interest capitalization for self-constructed assets gives a helpful overview. Last reviewed for accuracy: November 13, 2026, against FASB ASC 835-20.
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About The Author
Mansour Farhat teaches the Farhat Lectures courses for CPA, CMA, and EA candidates and accounting students. He also records the video lessons used throughout this guide, including the interest capitalization example above.
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