Capitalization of construction period interest.

In addition to providing uniform capitalization rules for inventory, IRC section 263A requires capitalization of interest expense associated with the production of real property and longer-term tangible personal property. Interim guidance on interest capitalization was found in IRS notice 88-89 (IRB no. 1988-36), but recently issued proposed regulations will provide expanded guidelines when the new regulations become final [proposed regulations 1.263A(f) of 8/16/91].

Under the 1988 IRS notice, it was clear that interest capitalization was required during construction of buildings and personal property with a class life of 20 years or more. The proposed regulations appear to expand the reach of these rules by including affixed permanent structures in the real estate definition.

These regulations would require interest capitalization on improvements not classified as buildings and with class lives under 20 years, including items such as fences, paved parking areas, railroad tracks, bridges, tunnels, towers, greenhouses, grain storage bins and the like. The regulations also clarify that the clearing of raw land before sale is considered a production activity requiring interest capitalization.

Observation: Even small businesses developing land or constructing buildings or other structures will need to address the capitalization-of-interest requirement. In addition to capitalizing interest directly traced to the constructed asset, the regulations would force capitalization of interest associated with other business debt under the "avoided cost" calculation method.