Compounding of interest

Interest capitalization refers to the accounting process whereby interest incurred is not recorded as a current expense but is added to the capital-that is, the acquisition or construction cost of an asset. In the real estate sector, this is particularly relevant for construction projects: interest on debt incurred during the construction phase may, under certain conditions, be capitalized and thus recognized as part of the construction costs. This has direct implications for depreciation, tax liability, and balance sheet presentation.

Capitalization of Interest under the German Commercial Code (HGB) and IFRS

Under the German Commercial Code (HGB), the capitalization of construction interest is optional (Section 255(3) HGB): borrowing costs attributable to the construction period may be added to the construction costs. The prerequisite is that the interest can be clearly allocated to the construction period-that is, the phase during which the building is actually being constructed or fundamentally renovated.

Under International Financial Reporting Standards (IFRS), specifically IAS 23, the capitalization of so-called borrowing costs is mandatory, however, provided that a qualifying asset exists-that is, an asset that requires a significant period of time to construct. Real estate constructed for sale or long-term leasing typically falls under this category. For real estate companies that report under IFRS (e.g., publicly traded REITs or international project developers), interest capitalization is therefore mandatory, which makes it difficult to compare their financial statements with those of companies reporting under the German Commercial Code (HGB).

Tax Treatment in Germany

In German tax law, there is no direct equivalent to interest capitalization under commercial law: Interest is generally an immediately deductible business expense, provided the asset is part of the business assets. For private individuals who rent out a property, financing interest is deductible as income-related expenses against rental income-even during the construction phase, provided the intention to rent it out later can be demonstrated.

Capitalization for tax purposes is generally not an option here. This means: For tax purposes, construction interest is deducted as income-related expenses in the year it is incurred, thereby reducing taxable income in the year of construction. Under commercial law, however, the company may choose whether to expense the interest immediately or capitalize it. This option is an important tool of accounting policy that should be carefully coordinated with a tax advisor.

Impact on Property Valuation and the Balance Sheet

If interest is capitalized, the book value of the property increases-and with it, the subsequent depreciation base. This leads to higher depreciation in subsequent years, which in turn reduces the tax burden. At the same time, a higher total assets figure on the balance sheet does not automatically improve the equity ratio; experts refer to this as “balance sheet policy,” which must be carefully weighed.

A practical example: A developer constructs an apartment building over 24 months with interest on borrowed capital of 60,000 euros per year (120,000 euros total). If he capitalizes this interest, the construction costs increase by 120,000 euros-and thus the annual depreciation base. With a 50-year useful life and a 2% depreciation rate, he saves €2,400 in taxes annually through higher depreciation. Alternatively, he can deduct the interest immediately as business expenses-which reduces the tax burden more directly in the year of the deduction. Which option is more advantageous depends on the individual tax rate and the income situation.

Practical Tip for Property Owners in Nuremberg and Franconia

Especially for new construction or renovation projects in Nuremberg and the surrounding area, significant interim financing interest accrues during long construction phases. Large construction projects in the region-such as multi-family housing developments in up-and-coming neighborhoods or new commercial buildings in the business park-can quickly generate six-figure amounts in construction interest.

Whether and to what extent these should be capitalized is a question that tax advisors and accountants must answer on a case-by-case basis-depending on the legal form, accounting requirements, and strategic tax planning. We recommend clarifying the issue of interest capitalization with your tax advisor before construction begins to ensure you do not miss out on any tax planning opportunities. Upon request, we are happy to provide contacts to tax advisors in Nuremberg who specialize in real estate.

Frequently Asked Questions

Can a GmbH always capitalize construction interest?

A GmbH that prepares its financial statements in accordance with the German Commercial Code (HGB) has, pursuant to Section 255(3) HGB, an option to capitalize interest on borrowed capital during the construction phase. The prerequisite is that the interest can be clearly attributed to the construction period. There is no obligation to capitalize under the HGB, but there is under IFRS. The decision should be made deliberately and in consultation with a tax advisor, as it affects balance sheet ratios and tax planning over many years.

How does interest capitalization affect depreciation?

Capitalized interest increases construction costs and thus the depreciation base. With a useful life of 50 years and a depreciation rate of 2% per annum, the additional expense is spread over the entire useful life-this reduces the annual tax burden moderately but continuously. Compared to an immediate deduction as a business expense, the tax effect is thus spread over a longer period, but the total amount is not lower.

Is interest capitalization also relevant for private individuals?

For private individuals without commercial real estate activities, interest capitalization is not relevant in an accounting sense. However, interest incurred during the construction phase of a rental property is tax-deductible as prepaid income-related expenses, provided the intention to rent out the property can be demonstrated. This should be documented through lease negotiations, copies of advertisements, or written letters of intent-in the event of a dispute with the tax authorities, this evidence is crucial.

What exactly are borrowing costs under IAS 23?

According to IAS 23, borrowing costs include all debt financing costs that can be directly attributed to a qualifying asset: interest on bank loans, amortization of discounts or premiums on bond issuances, interest on lease liabilities (under IFRS 16), and exchange rate differences from foreign currency loans (to the extent they are treated as interest adjustments). For large real estate projects, this can result in significant amounts being capitalized, which significantly impact the balance sheet and earnings during the construction years.

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