30 Jul Leasing New Equipment?
By Trent Wolfe
Have you been considering leasing equipment as a result of the smaller margins in corn and soybeans? Your bank or dealership may even have contacted you about lease transactions for new equipment recently as grain prices continue to stay at lower levels compared to the past several years and depreciation rules are not getting updated in a timely fashion. Leasing equipment has some benefits, but you must be careful how you enter the lease agreement. The benefits of a lease are the shorter term, normally the lease term is short enough for all maintenance to be covered under warranty, and the lease payment is a fixed amount that could be fully deductible when paid. For the annual lease payments to be deductible the lease has to qualify as an operating lease. The differences in operating vs capital leases is another topic that will not be discussed in this article. With this article we hope to make you aware of a couple pitfalls when entering into a lease if you are trading an asset you already own.
When you own an asset and then decide to trade in the equipment for a leased asset, the transaction is not considered a like-kind exchange. For tax purposes, it is as if you have sold the original asset, even though there has been no cash transaction. The sales price of this paper sale is the fair market value of the trade-in asset. The value received for the trade-in asset is then normally used to reduce the lease payments. This might occur on an annual basis with a small payment made each year or the lease might not require any payments for 2-3 years, depending on the lease terms and value of the trade-in assets. Since your trade-in asset’s value is reducing the annual lease payments, you might wonder what happens to the trade-in value that was treated as the sales price. This trade-in value is considered a lease deposit and will be amortized, similar to depreciation, over the lease term. This lease deposit is not eligible for the fast first year depreciation write-offs (Section 179 or Bonus Depreciation). This means you pay tax on the trade-in value and then have a deduction over the lease term.
With grain prices down and yields lost due to weather conditions, be cautious of equipment makers, dealers and lenders getting too creative. Below is an example of the differences in lease structure options. If you are contemplating a lease transaction and have additional questions, please contact our office.
Here is an example of how lease transactions would be treated if you traded in equipment you currently own outright:
A tractor owned by Farmer Fred, purchased 3 years ago for $150,000, was valued at $250,000 at time of purchase. Farmer Fred expensed the entire cost in the first year of purchase. He had been trading the tractor every 3 years. He decides to lease a new tractor on June 30th. The fair market value of the first tractor when he decides to lease the new tractor is $135,000. Farmer Fred was given a 4 year lease on the tractor and there is no purchase option at the end of the 4 years. The annual lease payments would be $36,000 per year. The annual payments for Farmer Fred will begin once Farmer Fred signs the lease agreement. Since Farmer Fred has a tractor worth less than the 4 annual lease payments, Farmer Fred only has one payment of $9,000. The $9,000 payment is due in 4 years, meaning Farmer Fred has no deductions until he makes the payment. In the current year, Farmer Fred reports an ordinary gain of $135,000, since the tractor was fully depreciated. Farmer Fred will get amortization of the $135,000 lease deposit over 48 months, but the first year he does not get a full year of amortization. He only gets 6 months of amortization or $16,875 ($135,000/48 months x 6 months). By doing this lease, Farmer Fred has a reported gain of $135,000 and a deduction of only $16,875. Farmer Fred has no cash to cover the tax due on the transaction. If you were to sell the tractor for $135,000 and enter into the lease, the gain remains the same, but now Farmer Fred would have a lease payment of $36,000 and remaining cash of $99,000 to cover the tax on the sale and use the remainder in the farm operation. Another option for Farmer Fred is to retain the tractor to use towards a purchase transaction, as a tractor is allowed to be traded for other equipment and not just another tractor. This would remove the gain transaction, keep the lease payment of $36,000 and allow a smaller cash purchase on a future asset purchase.