Construction loan accounting captures every dollar spent building a property and folds those costs into the asset’s recorded value rather than expensing them as they occur. Draws are recorded as they fund, costs accumulate in a Construction in Progress (CIP) account on the balance sheet, and the whole balance reclassifies to fixed assets when the building is ready for use. The principle underneath all of it: any cost necessary to bring the property to the condition and location for its intended use belongs in the asset’s basis. Get this wrong and you misstate the balance sheet, distort depreciation for years, and create tax problems that surface when the property is sold.
Recording Draws as They Fund
A construction loan doesn’t disburse at closing. The lender sets a draw schedule tied to project milestones, the borrower submits a draw request with supporting documentation, and an inspector typically verifies the work before funds release.
The accounting only recognizes a liability when cash actually arrives. Each funded draw increases both the CIP asset account and Notes Payable. If the total commitment is $5 million but only $1.2 million has been drawn, the balance sheet shows $1.2 million in each account. The remaining $3.8 million commitment is not a liability; those funds haven’t been deployed.
Lien waivers from subcontractors and suppliers accompany each subsequent draw request. They confirm that prior payments were received and that no mechanic’s lien will be filed for work already paid. Lenders won’t release the next round of funding without them, and the waivers double as documentation supporting the amounts recorded in CIP.
The Construction in Progress Account
CIP sits on the balance sheet as a non-current asset under property, plant, and equipment. It accumulates every capitalizable cost until the project is done, then empties into permanent asset accounts once the building is ready for use.
Nothing in CIP gets depreciated. The asset hasn’t been placed in service, so there’s no wear and tear to record. The balance just grows as draws fund, invoices clear, and interest accrues. That growing balance is also a management tool: comparing the running total against the original budget surfaces cost overruns early, and tracking draws against the lender’s schedule helps maintain covenant compliance.
Which Costs Belong in CIP
IRC 263A requires capitalizing both direct costs and a proper share of indirect costs allocable to produced property.1Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses GAAP applies the same principle. Missing capitalizable costs understates the asset’s basis and overstates current-period expenses, and that error ripples through depreciation schedules for years.
Hard Costs
Direct costs are the ones you can point to on the job site: raw materials, wages for workers physically building the structure, and payments to subcontractors. They tie directly to purchase orders, invoices, and the project budget. Every lumber delivery, concrete pour, and electrician invoice goes into CIP.
Soft Costs
Indirect costs support the project without producing physical construction. Architectural and engineering fees, permit and inspection fees, surveying costs, insurance premiums during construction, and property taxes incurred while the building goes up all qualify. Legal fees directly tied to the project, such as zoning work or construction contract negotiation, qualify as well.
The line between capitalizable and non-capitalizable soft costs trips up plenty of projects. General corporate overhead usually doesn’t get capitalized. Costs that wouldn’t exist without the construction project typically do. A job-costing system with a detailed chart of accounts is the best defense. Set up cost codes at the start of the project so every invoice gets classified consistently from day one rather than reconstructed at year-end.
Retainage
Most construction contracts let the owner withhold a percentage of each progress payment, typically 5% to 10%, until the project is complete. That withholding is leverage: it keeps the contractor motivated to finish and correct deficiencies.
Retainage creates its own accounting entry. On a $100,000 invoice with 10% retainage, you pay $90,000 and record the remaining $10,000 as a retainage payable. The full $100,000 still goes into CIP because the cost has been incurred. At project completion, the accumulated retainage is released and paid, clearing the liability. Failing to track retainage separately creates confusion during draw reconciliations and makes cash flow harder to manage in the final stages.
Interest Reserves
Some construction loans include an interest reserve, a portion of the loan proceeds set aside at closing to cover interest payments during the build. The mechanics are circular: you’re borrowing to pay interest on the money you’re borrowing. Interest accrues on the reserve balance from closing.
Draws against the reserve increase the loan balance like any other draw. The interest paid from the reserve is still real interest expense and follows the same capitalization rules under ASC 835-20 and IRC 263A(f). The reserve shifts cash flow timing so the borrower doesn’t need to make out-of-pocket interest payments during construction. It is not prepaid interest; it’s funded debt earmarked for interest.
Capitalizing Interest Under GAAP
ASC 835-20 governs interest capitalization for financial reporting. The reasoning is that interest paid while building an asset is part of what it cost to create that asset, so it belongs in the asset’s basis rather than the income statement. This is where construction accounting diverges most sharply from routine bookkeeping, and where mistakes get expensive.
When Capitalization Runs
Interest capitalization begins only when three conditions exist at the same time. Expenditures for the asset have actually been made. Activities necessary to ready the asset for its intended use are underway, such as site preparation, foundation work, or actual construction. Interest cost is being incurred on an outstanding debt obligation. If any one of these conditions drops away, capitalization pauses.
Capitalization stops when the asset is substantially complete and ready for its intended use. For a building, that’s typically when the certificate of occupancy issues or the space is otherwise ready for tenants or the owner’s operations. The standard doesn’t require actual use, only that the asset could be used.
Calculating the Capitalizable Amount
The capitalized amount is not the total interest paid on the construction loan. ASC 835-20 limits capitalization to “avoidable interest,” meaning the interest that theoretically could have been avoided if the project expenditures hadn’t been made. You apply a capitalization rate to the weighted-average accumulated expenditures (WAAE) for the period.
WAAE reflects the fact that costs don’t all occur on January 1. A $600,000 expenditure made October 1 has only been outstanding three months by year-end and weights at 3/12. If you also spent $1.2 million on April 1 (outstanding nine months, weighted 9/12), WAAE is $600,000 × 3/12 plus $1.2 million × 9/12, or $1,050,000. Multiply by the applicable interest rate to get capitalizable interest for the period.
When a specific construction loan can be identified with the project, use that loan’s rate on the portion of WAAE that doesn’t exceed the loan balance. If accumulated expenditures exceed the construction loan, multiply the excess by a weighted-average rate across the entity’s other borrowings. One hard ceiling: capitalized interest for any period cannot exceed the total interest incurred by the entity in that period.
Suspension During Delays
If construction is intentionally suspended for an extended period, interest capitalization stops. You can’t keep loading interest into the asset’s basis while the project sits idle by choice. Brief interruptions, externally imposed delays such as waiting for a permit, and delays inherent to the construction process don’t trigger suspension. The difference between capitalizing and expensing interest during a six-month pause can meaningfully shift both the asset’s basis and current-period earnings.
Capitalizing Interest for Tax
Tax rules for interest capitalization run parallel to GAAP with different thresholds. IRC 263A(f) requires taxpayers to capitalize interest paid or incurred during the production period on “designated property.”1Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses For construction projects, the most commonly triggered category is real property, which automatically qualifies because it has a “long useful life” under the statute.
Tangible personal property also qualifies if it meets any of these thresholds:
- Long-lived property with a class life of 20 years or more under Section 168.
- Two-year property with an estimated production period exceeding two years.
- One-year property with an estimated production period exceeding one year and estimated production cost exceeding $1,000,000.
Thresholds are evaluated at the beginning of the production period based on reasonable estimates, and the classification sticks even if actual costs or timelines differ from initial projections.2eCFR. 26 CFR 1.263A-8 – Requirement to Capitalize Interest
The production period starts when production begins and ends when the property is ready to be placed in service or held for sale. Interest on debt directly tied to production expenditures gets assigned to the project first. Interest on other debt is then assigned to the extent the entity’s total interest costs could have been reduced if those production expenditures hadn’t been incurred. Qualified residence interest is excluded from this allocation.1Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
The IRS has published detailed guidance on applying these rules to self-constructed assets, walking through avoided-cost interest and mixed-use debt.3Internal Revenue Service. Interest Capitalization for Self-Constructed Assets With multiple debt instruments and ongoing projects, the calculation gets intricate fast. Developers with projects exceeding a year and a million dollars should assume these rules apply.
Closing Out the Project
At substantial completion, the temporary construction loan converts to permanent financing or gets paid off and replaced. The transition ends the capitalization period and triggers the entries that close out the construction phase.
Reclassifying CIP to Fixed Assets
The accumulated CIP balance moves into permanent asset accounts. A final journal entry credits CIP to zero and debits the appropriate fixed asset accounts, such as Building and Land Improvements, for the total accumulated cost including hard costs, soft costs, and capitalized interest.4AccountingCoach. Construction Work-in-Progress If the project includes both depreciable improvements and non-depreciable land, allocate the costs between them, since land is never depreciated.
Closing costs or origination fees on the permanent loan are not part of the building’s cost. They’re deferred financing costs, amortized over the life of the new mortgage as a separate line item.
Placed in Service and Depreciation
The placed-in-service date is when the asset is ready and available for its specific use, regardless of whether it’s actually being used at that moment. A rental property is placed in service when it’s ready to rent, even if no tenant has signed a lease.5Internal Revenue Service. Depreciation Reminders That date triggers depreciation deductions.6Internal Revenue Service. Topic No. 704, Depreciation
The full capitalized cost basis built up in CIP becomes the depreciable basis. Depreciation method, recovery period, and convention are set as of the placed-in-service date. Commercial real property uses a 39-year recovery period under MACRS; residential rental uses 27.5 years. Components like landscaping, parking lots, and site improvements may qualify for shorter periods, which is why cost segregation studies are worth considering on larger projects.7Office of the Law Revision Counsel. 26 USC 167 – Depreciation
When a Project Stalls or Fails
Not every project reaches completion. Financing falls through, market conditions shift, costs go past feasibility. The accounting treatment depends on whether the project is impaired or fully abandoned.
Impairment
Under ASC 360-10, long-lived assets, including those still under construction, must be tested for impairment when events suggest the carrying amount may not be recoverable. For construction, the common trigger is cost overruns that push CIP significantly above the original estimate. A steep decline in the expected market value of the finished property can also trigger testing.
The test compares the asset group’s carrying amount to its total undiscounted future cash flows. If the carrying amount exceeds those cash flows, the asset is impaired, and the loss is measured as the difference between carrying amount and fair value. That loss hits the income statement in the period recognized. Monitoring CIP against projected property values throughout construction is how developers catch this before it becomes worse.
Abandonment
If a project is permanently abandoned, the entire CIP balance is written off as a loss. IRC 165 allows a deduction for losses sustained during the taxable year that aren’t compensated by insurance.8Office of the Law Revision Counsel. 26 USC 165 – Losses The abandonment must be genuine and permanent. Document the decision with board resolutions, internal memos, or correspondence with lenders showing the project will not resume.
Classification matters. An abandonment is generally treated as an ordinary loss rather than a capital loss, which is more favorable because ordinary losses offset ordinary income without the limitations that apply to capital losses. Don’t structure the abandonment as a sale or exchange, which can recharacterize the loss as capital and reduce its immediate benefit.
Fixing Capitalization Errors
Discovering that interest or other costs were expensed when they should have been capitalized, or the reverse, requires a formal accounting method change for tax purposes. The IRS treats the shift between expensing and capitalizing interest as a change in method of accounting, not a simple error correction.
The mechanism is Form 3115, Application for Change in Accounting Method. Most UNICAP-related corrections qualify as automatic changes, meaning no user fee is required and consent is granted upon timely filing, though the IRS retains the right to review.9Internal Revenue Service. Instructions for Form 3115 If the taxpayer is eligible, the form must be filed under the automatic change procedures, with the change identified by a Designated Change Number (DCN) from the applicable revenue procedure.
Filing produces a Section 481(a) adjustment that captures the cumulative effect of the error in a single tax year for favorable adjustments, or spreads it over four years for unfavorable ones. Catching errors early limits the size of the adjustment and avoids compounding the problem across depreciation schedules built on an incorrect basis.