Construction in Progress tax treatment works on a simple principle: while an asset is being built, every qualifying cost is capitalized into a holding account and generates no current deduction, and once the finished asset is placed in service that accumulated total becomes the depreciable basis you recover over years under MACRS. Getting this right matters in both directions. Expensing costs that should have been capitalized, or capitalizing costs that qualified for immediate deduction, can trigger IRS adjustments that compound the longer they go unfixed.
What Costs Get Trapped in CIP
A CIP account is a holding tank for every cost directly tied to producing a long-term asset that isn’t ready yet. The total becomes the asset’s tax basis when construction wraps up.
Direct costs are the ones you’d never incur if the project didn’t exist: raw materials, labor wages for workers physically building the asset, and subcontractor payments. Indirect costs support the construction process without becoming part of the physical structure, including construction supervision salaries, temporary utilities at the job site, and equipment rental during the build.
Soft costs sit in the same bucket. Architectural and engineering fees, building permits, zoning variance applications, mandatory inspections, and legal fees tied to the project are all capitalized into CIP rather than expensed in the year you pay them. A common mistake is treating soft costs as current operating expenses. An annual general business license is deductible; a project-specific building permit is a capital cost that gets added to basis.
Capitalized Interest
When you borrow to fund construction, interest on that debt during the build period is capitalized into the asset’s cost rather than deducted currently. Under Section 263A(f), interest capitalization applies to all self-constructed real property with no minimum cost or time threshold. For tangible personal property, interest capitalization kicks in only when the asset has a depreciable class life of 20 years or more, an estimated production period exceeding two years, or a production period exceeding one year with estimated costs above $1,000,000.1Internal Revenue Service. Interest Capitalization for Self-Constructed Assets Capitalization stops once the asset is placed in service. After that, ongoing interest becomes a regular deductible expense.
Why Capitalization Is Required
Federal tax law requires that costs of producing a long-term asset be added to the asset’s basis and recovered through depreciation rather than deducted in the year you pay them. The governing framework is the Uniform Capitalization Rules, or 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.2Office of the Law Revision Counsel. 26 US Code 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
The line between a repair and an improvement is one of the most litigated areas in tax law. Costs that maintain an existing asset in its current operating condition are generally deductible in the current year. Costs that materially improve an asset, restore it to a like-new condition, or adapt it to a different use must be capitalized.
Safe Harbors That Let You Expense Instead
Two IRS safe harbors let some costs skip CIP entirely, and both are worth checking before defaulting to capitalization.
The de minimis safe harbor lets a business with an applicable financial statement (audited, filed with the SEC, or similar) elect to expense items costing $5,000 or less per invoice or per item. Without an applicable financial statement, the threshold drops to $2,500.3Internal Revenue Service. Tangible Property Final Regulations The election applies per item, not per project, so individual components of a larger capital project can qualify. You make the election annually on your tax return.
The routine maintenance safe harbor, in 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 the maintenance more than once during the asset’s class life. For buildings, the benchmark is more than once every ten years. Work that rises to the level of a betterment, restoration, or adaptation to a new use is excluded and must still be capitalized.
When Depreciation Begins
Costs sitting in a CIP account produce zero tax deductions. Depreciation starts 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 hasn’t found a tenant is already placed in service.4Internal Revenue Service. Depreciation Reminders
On the placed-in-service date, the entire CIP balance transfers out of the holding account and into the appropriate fixed asset category. That transferred total becomes the asset’s original depreciable basis. The date determines which tax year’s rules apply and when the first deduction hits.
A building can be placed in service with punch-list items remaining, as long as the structure is substantially complete and usable for its intended purpose. If the IRS questions your placed-in-service date, you’ll want occupancy certificates, inspection sign-offs, or evidence that the asset was actively marketed or used.
MACRS Recovery Periods
Once placed in service, most business assets are depreciated under the Modified Accelerated Cost Recovery System (MACRS), which assigns each asset type a specific recovery period and method.5Internal Revenue Service. Publication 946 – How To Depreciate Property The recovery periods most relevant to construction projects are:
- Residential rental property: 27.5 years, straight-line
- Nonresidential real property: 39 years, straight-line
- Land improvements such as fences, sidewalks, and parking lots: 15 years
- Personal property including most equipment and fixtures: 5 or 7 years, depending on the asset class
Cost Segregation Studies
A cost segregation study breaks apart the total cost of a building and reclassifies components that qualify for shorter recovery periods. Electrical systems serving specific equipment, decorative millwork, specialty flooring, and site improvements can often be pulled out of the 39-year bucket and placed into 5, 7, or 15-year categories. For any building project above a few hundred thousand dollars, the accelerated depreciation typically pays for the study many times over.
Qualified Improvement Property
Improvements to the interior of a nonresidential building after it’s been placed in service can qualify as Qualified Improvement Property (QIP), carrying a 15-year recovery period instead of 39. The work must be limited to the interior. Roofing, exterior HVAC, and window replacements don’t count, and the improvements cannot enlarge the building, install elevators or escalators, or modify the internal structural framework. Initial construction doesn’t qualify; only post-placement-in-service improvements do.
Bonus Depreciation After the OBBBA
Bonus depreciation is not available while an asset sits in CIP. It applies only in the year the asset is placed in service, but the payoff for waiting can be substantial. Under changes made by the One Big Beautiful Bill Act, the bonus depreciation 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 or later, the entire 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 (27.5 and 39-year property). Paired with a cost segregation study, 100% bonus depreciation can convert a substantial portion of a new building’s cost into a first-year deduction, because components reclassified to 5, 7, or 15-year lives all qualify for the full write-off.
Abandoned Projects
If a project is permanently abandoned, not sold, not repurposed, but genuinely discarded, the costs accumulated in CIP can be deducted as an ordinary loss. That treatment is more favorable than a capital loss, which faces limits on deductibility.
The abandonment must be absolute, with no intent to recover the costs or revive the project. The IRS will look for board resolutions documenting the decision, correspondence with contractors terminating the work, or other records showing the project was conclusively scrapped. A claim that leaves open the possibility of resuming the project won’t survive scrutiny. Structuring the exit as a sale or exchange of the partially completed work changes the character from an ordinary loss to a capital transaction, which can limit your ability to use the loss.
A Different Rule for Contractors
Everything above assumes you’re building an asset for your own use. Construction companies building under contract for a customer follow a different regime. When a construction contract spans more than one tax year, it’s a long-term contract under Internal Revenue Code Section 460, and the default rule requires the contractor to report income under the Percentage of Completion Method, recognizing a share of contract revenue and expense each year based on costs incurred against estimated total costs.7Office of the Law Revision Counsel. 26 US Code 460 – Special Rules for Long-Term Contracts The Completed Contract Method, which defers all recognition until finish, is available only to contractors meeting a gross receipts test or working on certain home construction contracts.
Fixing Prior Mistakes
If your business has been incorrectly expensing costs that should have been capitalized into CIP, or the reverse, you’ll generally file IRS Form 3115 to request a change in accounting method.8Internal Revenue Service. Instructions for Form 3115 Many CIP corrections qualify under the automatic change procedures, meaning you file the form with your return and owe no user fee. Non-automatic changes require 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, spreading the correction across the current and future tax years rather than requiring amended returns for every year affected. For a business that expensed costs it should have capitalized, the adjustment increases taxable income. For a business that failed to claim depreciation it was entitled to, the adjustment runs the other way. Either way, filing sooner limits the compounding effect of the error.