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Use Caution When Considering Farm Equipment Leases


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.

Pros
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.

Cons
Taxes

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.

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.

Conclusion

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. See an example here. 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.

Source: University of Nebraska CropWatch

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