Continued growth for a business is sometimes dependent on the company's ability to expand, replace outdated equipment or take advantage of profitable investments. To finance these activities, a company may choose to borrow funds for the project. The interest incurred on money borrowed for the project may be eligible for capitalization. Although a precise calculation requires knowing the exact amounts of expenses and related interest, it is possible to obtain a rough estimate of capitalized interest for a given period.
The Internal Revenue Service has strict guidelines for capitalizing interest. To capitalize interest, you must segregate expenditures into eligible and ineligible expenses. Eligible expenses must meet three tests. You must actually have made payments for the asset or project, work must be in progress to ultimately place the asset in service and the company must actually be incurring interest charges. Timing begins on the date of the first expenditure, which may include expenses incurred to prepare to start work on the project.
Timing of Expenses
Only expenses incurred prior to completion of the project are eligible for interest capitalization. The project is deemed complete when it is substantially complete, ready to be placed in service or work is abandoned on the project. Temporary work cessation, such as a work stoppage caused by inclement weather or a labor strike, does not disqualify the project. The requirement that interest capitalization cease when the asset is substantially complete is intended to prevent companies from deliberately delaying completion of a project in order to continue capitalizing interest.
Effective Interest Rate
Interest rates can be quite complicated, requiring a detailed spreadsheet or financial calculator to analyze. However, for contracts with simple rates, the effective interest rate can be determined by dividing the total interest paid by the average balance outstanding on the loan during the applicable time.
Estimated Capitalized Interest Calculation
Capital interest is limited to the amount actually incurred during the period in question and is also limited to only the amount of interest incurred that would not have been incurred had the project not been undertaken. A rough estimate of capital interest can be obtained by multiplying the average monthly amount of eligible expenses by the effective interest rate.
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