Industry Insights

The uniform capitalization rules of the Internal Revenue Code (IRC) require capitalization of interest expense to property produced by a taxpayer. “Produced” means constructed, built, installed, manufactured, developed, improved, created, raised or grown. This also includes production under a contract with another party.

While this is a straightforward concept, its application can be quite complex when property is produced by a partnership, especially when the partners contribute equity to fund the property’s production but have other indebtedness outstanding.

For example, assume that a real estate development partnership contracts with a general contractor to build a $20 million apartment complex. The partnership borrows $15 million, and the partners contribute $5 million of equity to fund construction. The $15 million of debt is directly traced to the project, and the interest expense during construction is capitalized into the basis of the project, as expected. However, the $5 million of equity funding will result in interest capitalization at the partner level, if the partners have other interest-bearing indebtedness outstanding from any other source during the construction period. This is because uniform capitalization rules require taxpayers to capitalize interest on debt that could be avoided by paying off the debt, in lieu of contributing equity to the partnership.

According to IRC Sec. 1.263A-9(a)(1), “any interest that the taxpayer theoretically would have avoided if accumulated production expenditures had been used to repay or reduce the taxpayer’s outstanding debt must be capitalized under the avoided cost method. The application of the avoided cost method does not depend on whether the taxpayer actually would have used the amounts expended for production to repay or reduce debt. Instead, the avoided cost method is based on the assumption that debt of the taxpayer would have been repaid or reduced without regard to the taxpayer’s subjective intentions or to restrictions (including legal, regulatory, contractual or other restrictions) against repayment or use of the debt proceeds.”

IRS Notice 88-99 and Revenue Procedure 2001-10 contain de minimis exceptions for small contracts and small taxpayers. For more information on these complex interest capitalization rules, contact your BKD advisor.