What Is Construction Interest Expense?

Construction interest expense is an interest that accumulates on a construction loan used to construct a building or other long-lived business asset.

Typically, interest paid on a loan is immediately expensed and is tax deductible but that isn't always the case. For example, construction interest expense that is incurred during the period up until the time the asset begins to produce revenue is capitalized by adding it to the cost basis of the asset.

Construction interest expense is treated differently than other types of business-related interest due to the nature of the business of construction.

How Construction Interest Expense Works

Construction interest that is incurred on the construction of a structure intended for rental or business use is not deductible at the time that it is paid. This type of interest is added to the cost basis of the asset instead. For this reason, it is also known as capitalized interest.

Capitalized interest is different than usual interest expenses because it does not show up as an expense on an income statement from the company.

Construction interest expense occurs when a company or person is building something for a profit.

There are various examples of long-term assets that allow for capitalizing interest, like shipbuilding, production facilities, and real estate.

Key Takeaways

  • Construction period interest capitalization represents the cost of financing the building of a long-term asset, such as a rental building. 
  • Construction interest expense is also called capitalized interest.
  • Unlike other forms of industry-related interest, construction interest expense is handled differently, because its interest cannot be deducted.

Example of Construction Interest Expense in Real Estate

In real estate, for example, when an owner takes out a construction loan to build a new property, the interest due on the loan is incurred by the owner during the period that the new home is being built.

When the building (let's assume it is a rental apartment building) is rented out and begins to generate income for the owner, then the interest, which has been accruing, is capitalized and becomes part of the cost basis of the building project.

Alternative Example of Construction Interest Expense

For example, XYZ corporation is building a new industrial-sized widget press. XYZ corporation takes out a loan to purchase the parts and erect the widget press and hopes it will be successful as a business venture.

Until the time the widget press is fully functional and starts to produce widgets for sale, the interest on the loan to build the widget press will be added up. Next, it will be added to the cost basis of the widget press, where it then will become part of the capitalized cost for the press.

This is a different treatment from all of XYZ corporation's other outstanding loans, where the interest is categorized as an expense immediately and is tax deductible. It is possible for the company to have numerous loans that were taken out to grow the business.