Yes, you can deduct capitalized interest as part of your student loan interest deduction. But you can't deduct it all at once. You have to deduct it as it's paid off each year. The following is from IRS Publication 970 (page 33).
Capitalized interest. This is unpaid interest on a student loan that is added by the lender to the outstanding principal balance of the loan. Capitalized interest is treated as interest for tax purposes and is deductible as payments of principal are made on the loan. No deduction for capitalized interest is allowed in a year in which no loan payments were made.
If your loan was made on or after September 1, 2004 the lender is required to include the capitalized interest in the total interest shown in box 1 of your Form 1098-E. In that case you don't have to do anything special. Just enter the total amount of interest shown on the 1098-E. It already includes the capitalized interest. If the loan was made before September 1, 2004, see if box 2 is checked on the 1098-E. If box 2 is not checked, the capitalized interest is included in box 1, the same as if the loan was made on or after September 1, 2004. If box 2 is checked, the capitalized interest is not included in box 1. In this case you would have to calculate the deductible amount yourself, and it's complicated. Publication 970 gives an example of how to do it, under the heading "Allocating Payments Between Interest and Principal," also on page 33.
You can download IRS Publication 970 from the following link on the IRS web site.
Publication 970, Tax Benefits for Education
