January 12, 2009

Economic efficiency is paramount to profitability in crop production operations. Machinery and production equipment represent major costs that have been on the rise in recent years. The National Agricultural Statistics Service reports that machinery and equipment expenses and fuel expenses increased by 11% and 14% respectively from 2006 to 2007 (NASS, 2008). These costs can challenge an operation's cash flow, but properly managing them can help producers effectively and efficiently recapture gross margin.

Before deciding whether to lease or own farm equipment, consider the advantages and disadvantages of each option. In this article, we'll examine the pros and cons of each, basic ownership costs, and the tax considerations related to making an equipment decision. Another option, joint ownership, is discussed in Share Machinery, Reduce Costs.

Advantages

Leasing Equipment. Advantages characteristic of leasing farm equipment include:

• Lower up-front, down payment costs compared to purchasing
• Payments often are less than traditional loan payments would be
• Less liability on the balance sheet
• Equipment available for short-time needs
• Access to and use of latest technology
• Lease payments are considered production expenses for tax purposes

Buying Equipment. Advantages characteristic of buying farm equipment include:

• Owned equipment may be easily replaced or sold at the owner's discretion; replacing leased equipment may be more difficult.
• Owned equipment has asset value and may be used as collateral against other loans.
• Purchases do not require security deposits, although down payments to secure financing may be higher.
• Purchased equipment has no use limitations. Some leases specify the number of hours a machine may be used before a penalty is imposed.
• Increased asset value on the balance sheet.

Why Companies Lease Equipment

The agricultural producer buys farm machinery primarily as a tool to improve or enhance the profitability of the operation. The leasing company buys farm equipment not for the purpose of farming, but as a tax incentive. To capture this incentive, the equipment must be used for agricultural production, thus, it is leased to farmers. Because of volume purchasing and capital structure, the leasing company can realize a greater return on its investment. To make the lease attractive to farmers, the leasing company passes some of this after-tax profit to the producer.

Characteristics of Purchase and Lease Options

Deciding whether to buy or lease equipment requires that you understand some base characteristics and how they affect cash flow and asset management.

Depreciation. It is necessary to understand the key components of farm machinery value and the change in value over time. The most difficult to evaluate is depreciative cost of equipment over time. Depreciation is defined as the decline in asset value over time. It also represents the basic ownership costs of a capital asset and the consumption of an asset's value over its useful life. This depreciative cost is most important when considering the effect of machinery on the farm tax position. The total cost of depreciation will be greatest in the early ownership of an asset and diminish over time. The following are terms you should know:

MACRS — Modified Accelerated Cost Recovery System

GDS — General Depreciation System. Under IRS GDS rules, farm machinery qualifies as a seven-year asset.

ADS — Alternative Depreciation System

Basis — The cost of the asset plus any sales tax and origination fees multiplied by the percentage of use in the business

Generally, all farm machinery is depreciated using the GDS system using the 150% declining balance method. There are tables available to help calculate the MACRS GDS rates. Table 1 represents the IRS Section 179 depreciation rates by tax year:

The individual farm cash flow and tax situation will vary from operation to operation. Section 179 of the IRS Tax Code allows producers to write off purchases on equipment, as long as they are not acquired from a related party. Before making a decision on leasing versus buying equipment, understand how each will affect your tax situation. Consult your tax professional to ascertain your current tax position.

Repair Costs. As equipment ages, the accumulated cost of repairs begins to mount. Repair costs should positively correlate with the total hours of equipment operation; the greater the accumulated hours of operation, the greater the accumulated cost of repairs. When deciding whether to buy or lease machinery, consider long-term repair costs. Usually the lessee is responsible for all repairs not covered by warranty, just as the owner would be. However, leased equipment may be replaced before repair costs begin to mount.

Research has shown that operators who can't perform repairs beyond routine maintenance may benefit more from leasing machinery. Leasing ensures that equipment is available when needed and is in generally good condition. Operators who have superior machinery management ability, or the ability to conduct repairs beyond routine operations, may benefit from the lower costs of owning older machinery.

The decision to lease or buy based solely on repair costs should strongly consider the mechanical competence of the operator and the maintenance state of the machinery.

Fuel and Lubrication. Self-propelled farm machinery has been shown to consume approximately .044 gallons of diesel fuel per hour per horsepower unit. Furthermore, research has demonstrated that, on average, farm operators run their equipment at 87% of the listed PTO max horsepower. Regardless of whether equipment is owned or leased, fuel consumption remains fairly constant with variations that are negligible in the decision making process.

More on Taxes. One way machinery leasing is advantageous to the producer is with tax management related to cash flow needs. For the producer, the lease is an operational expense, which means that the item may not be used as a depreciable asset (as discussed above), may not be used as a section 179 expense item, and the interest paid is not deductible through the interest category; however, the full payment of the lease is deductible as a production expense (Table 2).

In deciding whether to lease or buy machinery, the decision comes down to cash flow versus overall cost. The concept and maturation of the leasing industry has brought the cost of the lease close to the cost of overall purchase. The difference is in the tax and cash management preferences of the individual operator. Once again, it is important that you discuss purchases and leases with your tax professional to gain a full understanding of the effect on your cash flow and tax position.

Technology. One of the greatest advantages of leasing is that it does not lock the operator into long-term ownership of production assets, allowing the producer to access new technologies. On-farm research at land grant institutions has demonstrated the economic advantages of precision farming; however, actual savings depends on the operator's ability to apply the technology. Simply having technology is not a guarantee of economic return. The decision to buy or lease machinery based solely on acquiring the largest, fastest, strongest, most computerized machine does not ensure a positive net return. A producer should complete a side-by-side comparison of what is available in technology to what is expected in net overall return.
Tim Lemmons
Extension Educator

More: Now compare the economics of buying vs leasing.