Costs that can be capitalized on a project are those that create or improve an asset with a useful life extending beyond the current year: direct materials and labor, allocable overhead, outside professional fees, financing interest incurred during construction, qualifying software development work, and certain improvements to property you already own. These costs go on the balance sheet and are recovered through depreciation or amortization instead of being deducted all at once. Everything else — costs that would have been incurred anyway, or that simply keep property running — is expensed in the year paid.
The classification matters because it shifts deductions across years, changes reported earnings, and sets the basis you’ll depreciate for the life of the asset. Both GAAP and the federal tax code police the line, and the rules diverge in a few important places.
Direct Materials and Labor
The clearest capitalizable costs are the materials and labor physically consumed in building the asset. For construction, that means the steel, lumber, concrete, wiring, and similar components that end up in the finished product. When you build property or have it built, the IRS treats land, labor, materials, architect’s fees, building permit charges, contractor payments, rental equipment, and inspection fees as part of the asset’s cost basis.1Internal Revenue Service. Publication 551 – Basis of Assets
Direct labor covers the gross wages, payroll taxes, and benefits of employees whose time is spent on the project. An employee earning thirty dollars an hour who works forty hours a week exclusively on a build contributes twelve hundred dollars a week in wages, plus benefits, to the asset’s recorded value rather than to operating expense. Idle time and wasted materials don’t count; they’re expensed.
If you use equipment you already own during construction, the depreciation on that equipment for the construction period is folded into the new asset’s cost. The federal tangible property regulations require capitalizing all direct and allocable indirect costs of producing property, including resources consumed by your own existing assets during the build.2Internal Revenue Service. Tangible Property Regulations – Frequently Asked Questions
Overhead and Indirect Costs
Indirect costs that support the project without being physically built into it can be capitalized when they’re tied to the construction effort. Equipment rentals, site utilities, temporary security during the build, and insurance purchased specifically for the project qualify. Freight and handling charges for delivering materials to the site are part of the asset’s cost too.
Supervision can be capitalized with a reasonable allocation method. If a project manager oversees several crews on different jobs, only the portion of their salary tied to a given project attaches to that project. The allocation basis — labor hours, square footage, or something similar — needs to be consistent and documented.
General administrative costs stay off the balance sheet. Corporate headquarters rent, executive salaries, and office supplies are not capitalizable. The test is whether the cost would have been avoided if the project didn’t exist. If you’d have paid it anyway, it’s a period cost on the income statement.
Professional Fees and Permits
Fees paid to outside professionals during a project are added to the asset’s cost. Architect’s fees, surveyor charges, engineering evaluations, and inspection costs all increase basis. Legal fees for title searches, preparing deeds, and defending or perfecting title are capitalizable, as are zoning costs and building permit charges.1Internal Revenue Service. Publication 551 – Basis of Assets A $5,000 building permit becomes part of the project’s capitalized value, not a current-year deduction.
These costs sit on the balance sheet until the asset is placed in service and depreciation begins. Without the legal clearance, engineering approval, and zoning compliance they buy, the project couldn’t legally proceed, which is why the tax code treats them as part of the asset.
Interest on Project Financing
Interest on debt used to finance a project must be capitalized during construction rather than deducted currently. Under GAAP (ASC 835-20), the capitalization period begins when three conditions are met at the same time: expenditures for the asset have been made, activities to prepare the asset are underway, and interest costs are being incurred. Interest keeps getting added to the asset’s value until the project is substantially complete and ready for its intended use.
For federal tax purposes, the avoided cost method drives a similar result in two layers. Interest on debt directly traceable to the project — a construction loan, for example — is fully capitalized. If total project expenditures exceed the traced debt, additional interest on your other outstanding borrowings is also capitalized, calculated using a weighted average rate across that remaining debt.3eCFR. 26 CFR 1.263A-9 – The Avoided Cost Method
Once the asset enters service, interest capitalization stops. Subsequent interest payments become ordinary deductible expenses.
Software Development Costs
Software built for a company’s own use follows a stage-based framework under GAAP (ASC 350-40). The timing of a cost determines whether it hits the balance sheet or the income statement.
- Costs in the preliminary project stage — evaluating alternatives, selecting vendors, deciding on the technology approach — are expensed as incurred.
- Costs in the application development stage, once you’ve committed to a path and begun coding, configuring, installing hardware, or testing, are capitalized. This covers both external consultant fees and internal developer payroll.
- Post-implementation costs — ongoing maintenance, training, and minor bug fixes — are expensed.
FASB issued an updated standard in 2025 with targeted changes to this framework, including a new threshold focused on whether the project is probable to be completed. It takes effect for annual reporting periods beginning after December 15, 2027, with early adoption permitted.4FASB. FASB Issues Standard That Makes Targeted Improvements to Internal-Use Software Guidance The stage-based model above remains the default until then.
Cloud Computing Arrangements
If you pay for a cloud-based software service rather than software you own, the treatment depends on whether the arrangement includes a software license. When it’s classified as a service contract (you don’t control the underlying software), the ASC 350-40 stage-based framework still governs your implementation costs. Application-development-stage work such as configuration and data conversion is capitalized, but it appears on the balance sheet as a prepaid expense rather than an intangible asset, and it amortizes over the term of the hosting contract rather than the software’s useful life. Training costs are always expensed.
Improvements to Existing Property
Spending on property you already own doesn’t automatically become a deductible repair. The IRS uses the BAR test to decide whether an expenditure is an improvement that must be capitalized. A cost is a capital improvement if it results in a betterment, an adaptation, or a restoration of the property.2Internal Revenue Service. Tangible Property Regulations – Frequently Asked Questions
- A betterment fixes a pre-existing defect, adds significant size or capacity, or materially increases the property’s productivity, efficiency, strength, or output.
- An adaptation converts the property to a new or different use that’s inconsistent with its original use — turning a warehouse into a retail store, for example.
- A restoration replaces a major component or substantial structural part, returns non-functional property to working condition, or rebuilds property to a like-new condition after its expected useful life has ended.
The analysis is applied at the level of each “unit of property.” For buildings, the structure and each major building system (HVAC, plumbing, electrical, elevators, fire protection, security, gas distribution, and similar systems) are separate units.5eCFR. 26 CFR 1.263(a)-3 – Amounts Paid to Improve Tangible Property Replacing an entire HVAC system would likely be a restoration of that system even if it’s a small fraction of the building’s total value.
Routine Maintenance Safe Harbor
Not every recurring maintenance cost triggers capitalization. The IRS offers a safe harbor for routine maintenance, meaning recurring activities you expect to perform to keep property in ordinary operating condition. For buildings, the activity must be one you reasonably expect to perform more than once during the ten-year period beginning when the building is placed in service. For non-building property, the timeframe is the asset’s class life.2Internal Revenue Service. Tangible Property Regulations – Frequently Asked Questions The safe harbor covers costs that might otherwise be restorations; it doesn’t shelter betterments.
De Minimis Safe Harbor for Small Purchases
Low-cost items that might technically qualify as capital assets can be expensed immediately under the de minimis safe harbor. Businesses with an applicable financial statement (audited financials, an SEC filing, or similar) can expense items costing up to $5,000 per invoice or per item. Without an applicable financial statement, the threshold is $2,500 per invoice or item.2Internal Revenue Service. Tangible Property Regulations – Frequently Asked Questions
To use the safe harbor, attach a statement titled “Section 1.263(a)-1(f) de minimis safe harbor election” to your timely filed federal tax return (including extensions) for the year the costs are paid. The election is annual, not a permanent accounting method change, so Form 3115 isn’t required to start or stop using it. Once elected, the safe harbor applies to all qualifying expenditures for the year; you can’t pick and choose which items to include.
UNICAP for Larger Producers and Resellers
Businesses that produce real or tangible personal property, or acquire property for resale, are generally subject to the uniform capitalization rules under Section 263A (often called UNICAP). These rules require capitalizing both direct costs and a share of indirect costs allocable to production or acquisition, including items like warehouse rent, purchasing department salaries, and depreciation on production equipment that might otherwise sit in overhead.6eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs
Small businesses are exempt. If average annual gross receipts over the prior three tax years are at or below the inflation-adjusted threshold — $32 million for tax years beginning in 2026 — UNICAP does not apply.7Internal Revenue Service. Revenue Procedure 2025-32 The threshold is adjusted annually, so it’s worth rechecking each year. Businesses above it must follow UNICAP’s detailed allocation methods when calculating the cost basis of property they produce or acquire for resale.
Section 179 and Bonus Depreciation
A cost being capitalized doesn’t always mean the deduction has to be spread over many years. Two provisions let you recover capitalized costs much faster, sometimes immediately.
- Section 179 lets eligible businesses elect to deduct up to $2,560,000 of the cost of qualifying property (equipment, machinery, certain software, and some building improvements) in the year it’s placed in service for 2026. The deduction phases out dollar-for-dollar once total qualifying purchases exceed $4,090,000 in a given year. The property must be used in your trade or business more than 50% of the time.
- Bonus depreciation covers qualifying new and used property placed in service in 2026 at 100%, allowing the full cost to be deducted in the first year. Full expensing was restored by recent legislation after a phase-down period that had reduced the rate in prior years.8Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System
Neither provision changes whether a cost is capitalized. The expenditure still goes on the balance sheet as an asset. They accelerate the tax deduction, which can meaningfully reduce the tax bill in the year property enters service. Land and most buildings are excluded from bonus depreciation, so the specific project type matters.
When Capitalized Costs Come Off the Books
Capitalized costs don’t stay on the balance sheet forever if a project falls apart. When a project is formally abandoned before completion, the capitalized costs generally become deductible as a loss in the tax year the abandonment occurs. To claim it, you need to show both the intent to abandon and an actual cessation of activities; continuing to explore alternative uses for the asset can undermine the claim. The loss is only available in the year of abandonment.
For financial reporting under GAAP, capitalized project costs must be tested for impairment whenever circumstances suggest the recorded value may not be recoverable. Common triggers include a steep drop in market value, a major adverse change in how the asset is being used, cost overruns significantly exceeding original estimates, or ongoing operating losses tied to the asset. If testing confirms the carrying amount exceeds the future cash flows the asset can generate, the difference is recognized as an impairment loss on the income statement.
Costs expected to be recovered through insurance proceeds shouldn’t be claimed as an abandonment loss. Documentation of project milestones, decision points, and cost records is what supports either an abandonment deduction or an impairment write-down when the return is examined.