Rent is included in cost of goods sold only when the rented space is used for manufacturing, production, or off-site storage of inventory. Rent for offices, retail sales floors, and administrative space is an operating expense, deducted in the period you pay it. The dividing line is what happens inside the building: if goods are being made or held for resale there, the rent attaches to inventory and hits COGS when those goods sell. Everything else is a period cost.
When Rent Belongs in COGS
The IRS treats rent as a production overhead cost when the rented space houses manufacturing or processing activity. Publication 334 states that overhead expenses “such as rent, heat, light, power, insurance, depreciation, taxes, maintenance, labor, and supervision” that are “direct and necessary expenses of the manufacturing operation are included in your cost of goods sold.”1Internal Revenue Service. Publication 334 (2025), Tax Guide for Small Business
That treatment is backed by Section 263A of the Internal Revenue Code, the Uniform Capitalization (UNICAP) rules. Section 263A requires businesses to capitalize both direct costs and a proper share of indirect costs into inventory rather than deducting them immediately.2Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
The practical effect for a manufacturer: rent on the factory doesn’t reduce profits the month you pay it. It gets folded into the cost of the inventory you’re building, sits on the balance sheet inside work-in-process or finished goods, and only moves to the income statement as COGS when the product sells.
When Rent Is an Operating Expense
Rent for any space that doesn’t directly support production is a period cost and reported under selling, general, and administrative expenses. Corporate headquarters, regional sales offices, accounting departments, executive suites, and standalone retail showrooms all fall here.
Period costs hit the income statement immediately in the month incurred, whether or not the business sells anything that month. If January’s office rent is $5,000, that full amount reduces January’s profits even if every unit manufactured sits unsold in the warehouse. There’s no deferral, and no connection to inventory value. On the income statement these expenses appear below the gross profit line: they reduce operating income but leave COGS and gross margin alone.
Splitting Rent in a Mixed-Use Building
Most businesses don’t operate in single-purpose buildings. A manufacturer might have its assembly line, executive offices, and shipping department under one roof. When a single rent payment covers both production and non-production space, the total has to be allocated.
Square footage is the most common allocation method for rent. Measure how much floor space serves production versus administration or sales, then split the rent in that ratio. If 60% of a building houses the production line and 40% holds offices and a showroom, 60% of the rent gets capitalized into inventory and 40% is deducted as an operating expense.
Whatever method you use needs to be reasonable and applied consistently. Switching allocation methods from year to year without justification invites scrutiny. Some businesses use direct labor hours or machine hours as the base when those better reflect how the space supports production, but for rent, square footage is usually the cleanest approach.
Rent Rules for Retailers and Wholesalers
Resellers don’t manufacture anything, but UNICAP still applies to their inventory costs. The IRS requires resellers to capitalize indirect costs properly allocable to goods acquired for resale, and Treasury regulations specifically list rent as an occupancy expense subject to these rules.3GovInfo. 26 CFR 1.263A-3 – Rules Relating to Property Acquired for Resale
The key distinction for resellers is whether storage is on-site or off-site:
- Rent for off-site warehouses and storage facilities must be capitalized into inventory. A separate warehouse holding merchandise before it ships to customers is a classic off-site facility, and its rent becomes part of inventory cost until the goods sell.
- Rent for storage that is physically attached to and an integral part of a retail sales location can be expensed currently. The back room of a retail store, for example, doesn’t require capitalization of its storage costs.3GovInfo. 26 CFR 1.263A-3 – Rules Relating to Property Acquired for Resale
Facilities that serve both retail and off-site storage functions need the same kind of allocation manufacturers use for mixed-use buildings. The portion attributable to off-site storage gets capitalized; the on-site retail portion does not.
Service Businesses and SaaS Companies
If your business sells services rather than physical goods, COGS generally doesn’t apply. The Schedule C instructions specify that COGS is relevant when “the production, purchase, or sale of merchandise was an income-producing factor” in your trade or business.4Internal Revenue Service. Instructions for Schedule C (Form 1040) (2025) Consultants, accountants, lawyers, and freelancers deduct rent as an ordinary business expense on the relevant line of their return. There’s no inventory to capitalize into.
SaaS and digital product companies sit in a gray area. GAAP doesn’t clearly define what belongs in COGS for a SaaS business, and many companies treat cloud hosting and data center costs as COGS on the theory that those costs directly deliver the product. Unlike physical manufacturing, though, there’s no UNICAP mandate driving that classification for pure digital delivery. The treatment is largely a financial reporting choice guided by industry convention.
The Small Business Exemption From UNICAP
Not every business that produces or resells goods has to follow UNICAP. Section 263A(i) exempts any taxpayer (other than a tax shelter) that meets the gross receipts test under Section 448(c).2Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
That test looks at average annual gross receipts over the three preceding tax years. The base threshold is $25 million, adjusted annually for inflation.5Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting For tax years beginning in 2026, the inflation-adjusted figure is $32 million.6Internal Revenue Service. Rev. Proc. 2025-32
If your three-year average gross receipts stay under that threshold, you’re exempt from UNICAP’s capitalization requirements. You can generally deduct production-related rent in the year you pay it rather than running it through inventory. That’s a real simplification for small manufacturers and resellers. If the business grows past the threshold, you’ll need to begin capitalizing these costs going forward, and the transition is a change in accounting method.
Why the Classification Affects Your Financials
Where the rent lands changes reported profitability and the balance sheet. When factory rent is capitalized, it raises the per-unit cost of finished goods sitting in inventory. If those goods haven’t sold yet, the expense is deferred. That produces lower COGS, higher gross profit, and higher net income in the current period.
Classifying the same rent as a period expense does the opposite. It reduces current-period profits immediately through SG&A without increasing the inventory asset. For a business that manufactures more goods than it sells in a given period, the gap in reported income can be significant.
Misclassification in either direction creates real problems. Treating factory rent as an operating expense understates inventory value and inflates gross margin, making the production operation look more profitable per unit than it is. Treating office rent as a product cost overstates inventory and defers an expense that should have been recognized right away. Both distortions affect the financial statements that lenders, investors, and the IRS rely on. Document the allocation method, apply it consistently, and revisit it when the business changes how it uses its space.