The advantages and disadvantages of capitalizing interest for tax purposes lie in a company's ability to manage or manipulate both the period in which the capitalized interest is recognized as an expense on the income statement and by the way in which the capitalized interest is recognized on the income statement.
- Capitalized interest is associated with the cost of borrowing to acquire or construct a long-term asset.
- Unlike typical interest expenses, capitalized interest is not expensed immediately on a company's income statement.
- For tax purposes, you cannot deduct the full interest expense in the current period, but you can depreciate it over time.
What Is Capitalized Interest?
Capitalized interest refers to the cost of the funds used to finance the construction of a long-term asset that a company constructs. This treatment of interest is a requirement under the accrual basis of accounting and increases the amount of the fixed asset on a company's balance sheet.
When a company capitalizes interest, the cost of the interest is added to the book value of the long-term asset and is recognized as periodic depreciation expense on the income statement rather than as interest expense.
Tax Advantages of Capitalizing Interest
Depreciation expense is a pretax cost that reduces the profit of a company without reducing its cash flow.
When a company capitalizes its interest and adds the cost to its long-term asset, it effectively defers the interest expenses to a later accounting period. When it comes to taxes, the company can recognize the interest expense in the form of depreciation expense in a later period when its tax bill is higher. This reduces the amount of taxes that the company owes.
Tax Disadvantages of Capitalizing Interest
When a company is required to capitalize its interest on the loan used to construct a long-term asset, it cannot reduce its tax bill in the current period because the interest expense is deferred to a later period. It is unable to realize the tax benefits in the period for which the loan was taken out.
Example of Capitalized Interest
Consider a company that builds a small production facility worth $5 million with a useful life of 20 years. It borrows the amount to finance this project at an interest rate of 10%. The project will take a year to complete to put the building to its intended use, and the company is allowed to capitalize its annual interest expense on this project, which amounts to $500,000.
The company capitalizes interest by recording a debit entry of $500,000 to a fixed asset account and an offsetting credit entry to cash. At the end of construction, the company's production facility has a book value of $5.5 million, consisting of $5 million in construction costs and $500,000 in capitalized interest.
In the next year, when the production facility is used, the company books a straight-line depreciation expense of $275,000 ($5.5 million of the facility's book value divided by 20 years of useful life) of which $25,000, ($500,000 of capitalized interest divided by 20 years), is attributable to the capitalized interest.