Caution Urged on Farm Leases
Many factors in the agricultural economy are leading producers to consider a lease arrangement of new capital purchases instead of an outright purchase. It’s important that we consider both the pros and cons to this decision and that we consider what effect lease vs. purchase decisions have on the tax return.
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%.
Leasing equipment can make 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 for an example of how that might work.) We will also see improvement in the current ratio and working capital of the operation 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.
Leasing will keep you from having an asset that depreciates.
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 that is often made in the case for a lease is that you don’t see that depreciation because you don’t own the asset. On the other hand, by not owning you will 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 freeing up their leverage ratio to allow their equity to be used to purchase 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 take this advantage out).
- An operation that routinely trades equipment every year or two wouldn't have built equity in the asset anyway.
Detail on Tax Implications of LeasesFollowing is an excerpt from IRS Publication 535.
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 deduct the payment as rent but instead need to capitalize the asset as if you had purchased the item.
Most financial institutions that furnish equipment with lease agreements put taxes at the top of their list of reasons you should lease equipment, but as a tax preparer, I list taxes as the top con.
Tax law certainly allows that rental or leasing of farm assets is an “ordinary and necessary business expense.” It also clearly defines what is NOT considered a lease but rather a Conditional Sales Contract in IRS Publication 535.
In the leases I see there are many factors that trip the IRS 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.
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 the IRS 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 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 IRS’s definition of a true lease, there are management concerns with never building equity. We looked at a few types of operations that may benefit from having a lease but there is a long term downside to never building equity in the major pieces of equipment. Operations who 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 he should 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.
Examining One Farmer's Options
As an example, I had a producer call with just this question. He had been trading tractors every two years for many years and had recently switched to every year. 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 purchase and we discussed the option of not trading at all. His current loan payment was about $50,000 making this option the best for cash flow and reducing his expenses. Obviously, at some point, equipment needs to be replaced, but now is a great time to reconsider “habits” built during times of prosperity.
While understanding the tax implications of any decision is important, I encourage the producers I work with to look at this decision as to which one makes the most management sense (lower payments, better interest rate, etc.) for their operation.
Executive Director, Nebraska Farm Business Inc.
UNL Agricultural Economics