Caution for Farm Equipment Leases March 23, 2017
Many factors in the current agricultural economy are leading producers to consider a lease arrangement of new capital purchases instead of an outright purchase. When considering this option, it’s important to consider both the pros and cons as well as possible effects on your tax return.
A Positive Change to Your Balance Sheet
Reducing debt will improve the debt-to-asset ratio for a farm that has equity in asset (see box). The current ratio and working capital of the operation will also improve by removing that current debt from the balance sheet. Some lending institutions will include the upcoming lease payment as a current debt so this pro may depend on the individual.
No Asset Depreciation
Most farm equipment depreciates rapidly. The last few years have certainly been an exception to that generalization, but we are seeing the trend of prices for used equipment dropping again. One argument often made for a lease is that you don’t see the depreciation because you don’t own the asset. On the other hand, by not owning it you never build equity in the asset. The importance of this depends on the individual operation’s goals.
- A young or beginning farmer may look at leasing equipment as a means to free up their leverage ratio to allow for equity to be used to buy land someday.
- A small farmer may not have enough acres to spread out the ownership cost of a combine and leasing could allow him to use a good machine without such a large outlay (although the minimum hour requirements of many leases removes this advantage).
- An operation that trades equipment every year or two won’t build equity in the asset anyway.
Example of Balance Sheet Improvement
If you own a tractor that is worth $100,000 and you owe $80,000, you have entries on both sides of your balance sheet. The tractor is listed as an intermediate asset and the loan is listed in both the intermediate category (the remaining principle balance that is due in more than 12 months) and the current category (the payment that is due in the next 12 months plus any accrued interest).
Let’s assume your total assets with the tractor were $1,100,000 and your total debt was $280,000, your debt to asset ratio would be 25%. If you eliminated the tractor assuming the $20,000 of equity was paid in income taxes (see the Cons section), your new total assets would be $1,000,000 and your new total debt would be $200,000. Now your debt to asset ratio is only 20%.
Most financial institutions that furnish equipment with lease agreements put taxes at the top of their list of why you should lease equipment; however, as a tax preparer, I list it as the top con.
Tax law certainly allows that rental or leases of farm assets is an “ordinary and necessary business expense.” They also clearly define what they DON’T consider a lease, but rather a Conditional Sales Contract in IRS Publication 535.
In the leases I see there are many factors that trip IRS’s rules, but the most common is certainly a lease that has a stated or imputed interest value or does not have a true fair-market value buyout schedule in the end. In simpler terms, a true lease
- will not have an equal payment as the buyout,
- there won’t be a stated interest rate, and
- you won’t gain any equity in the asset.
Detail on Tax Implications of Leases
Following is an excerpt from IRS Publication 535, Conditional Sales Contract:
Whether an agreement is a conditional sales contract depends on the intent of the parties. Determine intent based on the provisions of the agreement and the facts and circumstances that exist when you make the agreement. No single test, or special combination of tests, always applies. However, in general, an agreement may be considered a conditional sales contract rather than a lease if any of the following is true.
- The agreement applies part of each payment toward an equity interest you will receive.
- You get title to the property after you make a stated amount of required payments.
- The amount you must pay to use the property for a short time is a large part of the amount you would pay to get title to the property.
- You pay much more than the current fair rental value of the property.
- You have an option to buy the property at a nominal price compared to the value of the property when you may exercise the option. Determine this value when you make the agreement.
- You have an option to buy the property at a nominal price compared to the total amount you have to pay under the agreement.
- The agreement designates part of the payments as interest, or that part is easy to recognize as interest.
If a lease agreement meets any of these tests, you are not allowed to deduct the payment as rent, but instead need to capitalize the asset as if you had purchased the item.
Deferred Tax Gain
Whenever a producer moves from owning an asset to leasing one, we have to deal with the sale of the old asset. Even if the dealer allows a “trade-in” of the value of the owned tractor on the lease of a new one (which pokes further holes in IRS’s view of a true lease), it is not a qualified like-kind exchange because you don’t own the new tractor. This means that you will need to recognize the gain on the sale of the old tractor when you dispose of it. If we had a tractor with a fair market value (FMV) of $100,000 and $0 basis assuming we’ve used all the depreciation (likely with the enhanced depreciation that we’ve enjoyed the past few years), you have a $100,000 gain and could easily recognize a $20,000 or higher tax bill as a result.
No Equity Builds
Regardless of the IRS definition of a true lease, there are management concerns with never building equity. A few types of operations may benefit from having a lease, but there is a long-term downside to never building equity in the major pieces of equipment. Operations that can get ahead of the debt load and build equity in equipment will have that net worth and eventually improved cash flow for not having the make those debt payments.
When a producer asks me whether to lease or purchase an asset, I often step back and evaluate the question based on two purchase options, throwing out the tax benefit of a “lease” until I find a lease agreement that meets IRS guidelines. While understanding the tax implications of any decision is important, I encourage producers to look at this decision based on which option makes the most management sense (lower payments, better interest rate, etc) for their operation.
Lease Decision Scenario
For example, a producer I work with had been trading tractors every two years for many years and had recently switched to every year. He was at his dealer's and the salesman was back with what they could do to trade this time.
- The quote was $85 per hour for two tractors that had a combined 1,200 hours or $102,000.
- The lease option was a two-year commitment. It was $30,000 per year, per tractor for 1,200 hours or a total of $60,000 per year.
The producer called me with the tax concern of selling his current tractors and the fact that he wouldn’t be building equity with the lease option. On the other hand, he was thinking he would be locking in the equity he’d built in his current machines. He had already dismissed the option to buy, but we discussed the option of not trading at all. His current loan payment was about $50,000, making this the best option for cash flow and reducing his expenses. Obviously, at some point equipment will need to be replaced, but this is great time to reconsider “habits” built during times of prosperity such as routinely replacing equipment.