Capitalized Interest

Capitalized interest is interest on a debt that is added to the principal balance of the loan rather than being expensed immediately on the income statement. This treatment applies when borrowing costs are directly attributable to the construction or acquisition of a qualifying asset, such as a building, manufacturing plant, or ship, that takes a substantial period of time to prepare for its intended use. Under U.S. GAAP, the rules governing capitalized interest are found in Accounting Standards Codification Topic 835-20. The capitalized amount becomes part of the asset's cost basis and is then expensed through depreciation over the asset's useful life.

Think of capitalized interest like fertilizer used to grow a crop: the cost is absorbed into the growing asset rather than written off immediately, because it contributed to creating the final product.

Only Qualifying Assets Trigger Capitalization

Not all interest can be capitalized. GAAP requires capitalization only when an asset takes a substantial period of time to construct or produce for its intended use, and when interest costs are actually being incurred during that construction period. Qualifying assets include real estate under construction, ships and other vessels being built, custom manufacturing equipment, and long-term infrastructure projects.

Interest on assets that are already in use, inventories produced in large quantities through continuous or serial manufacturing, and assets acquired as a complete unit do not qualify. A retailer who buys a finished warehouse and finances the purchase with a mortgage does not capitalize the mortgage interest. A developer who builds that same warehouse from the ground up does.

The Capitalizable Amount Is the Lower of Actual or Avoidable Interest

You must calculate two figures: actual interest incurred during the period and avoidable interest, which is the amount you would have avoided if you had not made the qualifying expenditure. You capitalize the lower of the two. This prevents companies from inflating asset values by capitalizing more interest than was actually caused by the construction project.

The interest rate used in the calculation comes from the specific borrowings made to fund the project. If general-purpose borrowings are also used, a weighted-average rate of all outstanding debt applies to the excess expenditure above the specific borrowings.

The Tax Treatment Follows Different Rules Under IRC Section 263A(f)

For U.S. federal income tax purposes, Internal Revenue Code Section 263A(f) governs interest capitalization. The rules differ from GAAP in several respects, including the definition of qualifying assets and the method for allocating interest. Taxpayers who are required to capitalize interest for tax purposes must do so even if they are expensing it for book purposes. The difference creates a deferred tax liability that reverses as the asset is depreciated.

Sources:
https://www.fasb.org/st/summary/stsum34.shtml
https://www.accountingtools.com/articles/capitalized-interest.html
https://corporatefinanceinstitute.com/resources/accounting/capitalized-interest/
https://www.irs.gov/businesses/corporations/uniform-capitalization-rules