The tax treatment of construction in progress works like this: every direct cost, allocable indirect cost, and capitalized interest dollar spent building a long-term asset sits in a Construction in Progress (CIP) account and generates no deduction while the project is underway. Once the asset is placed in service, that accumulated total becomes its depreciable basis and starts flowing out through MACRS depreciation, potentially accelerated by cost segregation and bonus depreciation. Get the categorization wrong in either direction and you face IRS adjustments that compound with every passing year.
What Costs Have to Be Capitalized
The governing rule is the Uniform Capitalization Rules (UNICAP) in Internal Revenue Code Section 263A. Any taxpayer producing real or tangible personal property must capitalize both direct costs and the property’s share of allocable indirect costs.1Office of the Law Revision Counsel. 26 US Code 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses While the asset is under construction, virtually everything from site preparation to architectural design gets folded into basis rather than deducted.
Direct Costs
These are the expenses you wouldn’t incur without the project: raw materials, wages for workers physically building the asset, and subcontractor payments. They’re the easiest to trace and the least controversial CIP entries.
Indirect and Soft Costs
Indirect costs support the construction without becoming part of the physical structure. Construction supervisor salaries, temporary utilities at the job site, and equipment rental during the build all belong here. So do soft costs: architectural and engineering fees, building permits, zoning variance applications, mandatory inspections, and legal fees tied to the project.
A frequent mistake is treating soft costs like ordinary operating expenses. An annual business license is deductible, but a project-specific building permit is a capital cost that adds to the asset’s basis.
Capitalized Interest
Interest on debt used to fund construction has to be capitalized into the asset’s cost during the build, not deducted currently. Under Section 263A(f), this applies to all self-constructed real property with no minimum cost or time threshold. For tangible personal property such as specialized equipment, interest capitalization is required only when the asset has a depreciable class life of 20 years or more, an estimated production period longer than two years, or a production period longer than one year with estimated costs above $1,000,000.2Internal Revenue Service. Interest Capitalization for Self-Constructed Assets Once the asset is placed in service, interest capitalization stops and ongoing interest on the same debt becomes a regular deductible expense.
Costs You Can Still Expense
Not every construction-related invoice has to run through the capitalize-and-depreciate cycle. Two safe harbors are worth checking before you send a cost to CIP.
De Minimis Safe Harbor
If your business has an applicable financial statement (an audited statement, an SEC filing, or similar), you can elect to expense items costing $5,000 or less per invoice or per item. Without an applicable financial statement, the limit is $2,500.3Internal Revenue Service. Tangible Property Final Regulations The election applies per item, so individual components of a larger project can qualify even when the project as a whole is clearly capital. You make the election each year on your return.
Routine Maintenance Safe Harbor
Treasury Regulation 1.263(a)-3(i) lets you deduct costs for inspecting, cleaning, testing, and replacing parts with comparable new ones, provided that when the property was placed in service you reasonably expected to perform that maintenance more than once during the asset’s class life. For buildings, the benchmark is more than once every ten years. This safe harbor does not reach work that rises to a betterment, restoration, or adaptation to a new use; those still have to be capitalized.
When Deductions Actually Start
Costs sitting in CIP produce zero current deductions. Depreciation begins only when the asset is placed in service, which the IRS defines as the point when the asset is ready and available for its intended use, even if you haven’t started using it yet. A rental property that’s move-in ready but unrented is already placed in service.4Internal Revenue Service. Depreciation Reminders
On that date, the whole CIP balance transfers out of the holding account into the right fixed asset category (Buildings, Machinery, or whatever fits) and becomes the asset’s original depreciable basis. Nailing down the date matters because it fixes the tax year and rule set that govern your first year of depreciation.
A building can be placed in service with punch-list items still open, as long as it’s substantially complete and usable for its intended purpose. Keep records that support the date you claim: occupancy certificates, inspection sign-offs, evidence of active marketing or actual use. If the IRS challenges the date, that documentation is what carries the argument.
Depreciation Once the Asset Is in Service
Most business assets are depreciated under the Modified Accelerated Cost Recovery System (MACRS), which assigns each asset type a recovery period and method.5Internal Revenue Service. Publication 946 – How To Depreciate Property The periods that show up most often on the far side of a CIP account:
- Residential rental property: 27.5 years, straight-line
- Nonresidential real property: 39 years, straight-line
- Land improvements (fences, sidewalks, parking lots): 15 years
- Personal property: 5 or 7 years for most equipment and fixtures, depending on class
The spread matters more than it looks. A dollar in a 39-year building produces roughly $0.026 a year in depreciation; the same dollar in a 7-year asset produces about $0.143 a year. That gap is why the next two moves exist.
Cost Segregation
A cost segregation study breaks a building’s total cost apart and reclassifies components that qualify for shorter recovery periods. Electrical systems serving specific equipment, decorative millwork, specialty flooring, and site improvements can often move from the 39-year bucket into 5, 7, or 15-year categories. For any building project above a few hundred thousand dollars, the study typically pays for itself many times over.
Qualified Improvement Property
Interior improvements made to a nonresidential building after it’s been placed in service can qualify as Qualified Improvement Property (QIP) with a 15-year recovery period instead of 39 years. The work has to be limited to the building’s interior. Roofing, exterior HVAC, and window replacements don’t count. Enlargements, elevators or escalators, and changes to the internal structural framework are also excluded. Initial construction doesn’t qualify; only post-placement improvements do.
Bonus Depreciation
Bonus depreciation isn’t available while the asset sits in CIP. It applies in the placed-in-service year. Under the One Big Beautiful Bill Act (OBBBA), the bonus rate was permanently restored to 100% for qualified property acquired and placed in service after January 19, 2025.6Internal Revenue Service. Interim Guidance on Additional First Year Depreciation Deduction For assets placed in service in 2026 and later, the full cost of qualifying property, including assets that spent years in CIP, can potentially be deducted in the first year. Qualifying property generally means MACRS property with a recovery period of 20 years or less. That covers equipment, land improvements, and QIP, but not the building structure itself at 27.5 or 39 years.
Paired with a cost segregation study, 100% bonus depreciation can convert a substantial share of a new building’s cost into a first-year deduction, because the reclassified 5, 7, and 15-year components all qualify.
If You Abandon the Project
Sometimes a project dies. If it’s permanently abandoned, not sold and not repurposed, the accumulated CIP costs can come out as an ordinary loss, which is more favorable than a capital loss.
The operative word is permanently. The abandonment has to be absolute, with no intent to recover the costs or revive the project. Expect the IRS to ask for evidence: board resolutions documenting the decision, correspondence terminating contractors, or other records showing the project was conclusively scrapped. Claiming abandonment while keeping the door open to restarting will not hold up.
Also watch the transaction form. Selling the partially completed work or the rights to the project turns the loss into a capital transaction, which limits deductibility.
A Different Regime for Contractors
Everything above assumes you’re building an asset for your own use. If you’re a construction company building under contract for a customer and the job spans more than one tax year, it’s a long-term contract under Section 460, and the tax accounting rules are different.7Office of the Law Revision Counsel. 26 US Code 460 – Special Rules for Long-Term Contracts
The default is the Percentage of Completion Method. You recognize contract revenue and expenses each year based on the share of work completed, typically measured by costs incurred to date divided by estimated total costs.7Office of the Law Revision Counsel. 26 US Code 460 – Special Rules for Long-Term Contracts Spend 40% of estimated total costs by year-end, report 40% of expected profit.
The Completed Contract Method defers all revenue and expense recognition until the project finishes, which is friendlier to cash flow because the tax hits in a single year. It’s limited to contractors that meet a gross receipts test (generally those whose average annual gross receipts over the prior three years fall under an inflation-adjusted threshold) or to certain home construction contracts. Larger contractors are stuck with the percentage of completion method.
Fixing It If You’ve Been Doing It Wrong
If you’ve been expensing costs that should have been capitalized, or capitalizing costs you should have deducted, the fix is generally a change in accounting method on Form 3115.8Internal Revenue Service. Instructions for Form 3115 Many CIP-related corrections qualify under the automatic change procedures, meaning you file the form with your return and pay no user fee. Corrections outside the automatic list need advance approval from the IRS National Office, a user fee, and considerably more time.
Form 3115 includes a Section 481(a) adjustment that captures the cumulative effect of the prior error and spreads the correction across the current and future tax years, so you don’t amend a stack of old returns. Businesses that under-capitalized will see the adjustment increase taxable income; businesses that failed to claim depreciation they were entitled to will see it move in their favor. The sooner it’s filed, the less the error compounds.