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.
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.