Normally, you can claim a deduction on your federal income tax return for interest on debt related to your trade or business. If you use the proceeds of a loan partially for business and partially for personal or other purposes, you would have to allocate the interest based on how you use the proceeds. You could claim a business expense deduction for the portion of the interest that corresponds to business use of the proceeds of the loan.
But there are certain cases in which you have to capitalize the interest instead of claiming a current year deduction. According to the IRS, under the uniform capitalization rules you would have to capitalize the interest on debt equal to your expenditures to produce real property or certain tangible personal property. This includes property you produce to use in your business or to sell to customers.
You would have to capitalize the interest for property that you construct, build, install, manufacture, develop, improve, create, raise, or grow. This includes property produced for you under a contract. The types of property subject to uniform capitalization of interest include any type of real property, tangible personal property with a class life of 20 years or more for tax depreciation purposes, and tangible personal property with an estimated production period of more than 2 years. If the estimated production cost is more than $1 million, interest on the production of tangible personal property with an estimated production period of more than 1 year would also have to be capitalized.
When you capitalize interest the interest becomes part of the cost of the property. You recover the cost for tax purposes based on the type of property you produced. If the property you produced is inventory, you recover the cost through the cost of goods sold calculation. For other types of property used in your business, you would recover the cost through depreciation, amortization, or when you sell or dispose of the property, due to the increase in the basis of the property as a result of capitalizing the interest.
As indicated by J. Scott Golan on the BKD website, interest capitalization can become more complex in a partnership. When partners contribute equity to fund the production of the property, but there is debt outstanding, the interest capitalization may apply on the equity contributed. Interest that could have been avoided by paying off or reducing debt instead of contributing equity to the partnership must be capitalized. This is referred to as the avoided cost method. This method does not depend on whether the amounts expended for production would have actually been used to reduce debt.
More information on the capitalization of interest can be found in Treasury Regulation § 1.263A-8 Requirement to capitalize interest and in IRS Cost Segregation Audit Technique Guide – Chapter 6.1 Uniform Capitalization.
Cost Segregation Audit Technique Guide – Chapter 6.1 Uniform Capitalization, IRS
J. Scott Golan, Interest Capitalization Rules – A Reminder of the Complexities of Partnerships, BKD
Publication 535, Business Expenses, IRS
Treasury Regulation § 1.263A-8, U.S. Government Printing Office