I'm sitting here reviewing tax returns and thinking about questions clients have asked throughout the busy season. With the low commodity prices and tax law changes, many clients have asked about purchasing or leasing equipment. Discussions on leasing go beyond clients; I've also had conversations with lenders about how the new tax laws could help to lower interest rates on leases. One thing for certain is there is much confusion.
There are two types of leases: operating and capital. An operating lease is what most people think of when they hear the term "lease." You make payments for a period of time and have the option to purchase the equipment at the end of the lease for its fair market value. When a lessor/lessee gets too aggressive with leasing terms, the IRS may deem it to be a capital lease. This is because the farmer essentially has purchased the equipment and makes "lease" payments instead of principal and interest. If you enter into a capital lease, the IRS views it as the purchase of new equipment. However, because you have purchased the equipment, you must depreciate it -- not expense the lease payments.
So why is this so difficult? One area lessors and lessees get tripped up is the ambiguity in residual value (purchase prices at the end of the lease). There is no clear guidance but the IRS likes to see a 20% residual value. However, the real test is the economic substance of the transaction: will the lessee purchase the property at the end of the lease? To put it simply, the residual value must be high enough to make it an attractive deal for the lessee to purchase the equipment.
The new tax laws also put a wrinkle into leasing. Under the old tax laws, if you traded depreciated equipment for new leased equipment, it was deemed a sale. The gain was amortized for the term of the lease. Under the new tax law, 1031 exchanges (i.e. trades) are not allowed on equipment. So when you turn in your tractor and use the proceeds to pay down a lease, the gain is taxable regardless of the type of lease. The replacement equipment has a tax basis equal to its purchase price, but 100% bonus depreciation or Section 179 expensing are available for the immediate tax write-off.
So what is right for you? With the depressed market for equipment, many people are exploring leasing. Farmers can write off lease payments and turn in the equipment at the end of the lease. However, farmers are writing off payments over two or three years rather than taking Section 179 or bonus depreciation in the year of purchase. But beware of the fine print -- read lease agreements carefully to thoroughly understand the terms of the obligations.
Editor's Note: Tax Columnist Rod Mauszycki is a CPA and tax partner with the accounting firm of CliftonLarsonAllen, in Minneapolis, Minnesota.
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