Tax Consequences of Exchanging Owned Equipment for Leasing New Equipment
In the past, our farm clients considered buying equipment as a tax savings tool because they could use Section 179 deduction and bonus depreciation. However, with volatility in commodity prices, the soft market for used equipment, and greater concerns about debt, leasing equipment has become an increasingly attractive option. This leads to a question I am asked almost every week: What are the tax consequences if I exchange equipment I own for new equipment on a lease?
After several clients called to discuss exchanging equipment for a lease, I decided to do a little research. To my surprise, I found at least three different positions discussed in the marketplace. No wonder there is confusion! However, the real tax consequences are fairly straight forward, and there are only two basic types of leases: operating and capital.
If you are a cash basis farmer and want to use equipment as a down payment for a lease, there could be a tax consequence depending on how the lease is set up. I won’t go into much detail, but an operating lease is what most people think of when they hear the term “lease.” You make payments for a period of time and have the option to purchase the equipment at the end of the lease for its fair market value. When people get too aggressive with leasing terms, the lease sometimes becomes a capital lease. A capital lease is where the farmer essentially has purchased the equipment and makes “lease” payments instead of principal and interest.
To illustrate what happens, let’s say you have fully depreciated equipment worth $100,000 (trade in value) that you want to use to pay down the lease of a new combine. If you enter into an operating lease, you have effectively sold the old equipment to the implement dealer for its trade-in value. The sales proceeds are then applied to pay down the lease. Because the equipment was fully depreciated, you will pay tax on the sale of the old equipment. In this case, the farmer will recognize $100,000 of depreciation recapture in the year of sale. However, the IRS does allow the farmer to amortize the trade-in value over the life of the lease. If the lease was over a period of four years, the farmer can deduct $25,000 per year. Think about it like this, you pay the tax on the sale of old equipment upfront and get a corresponding deduction spread out over the term of the lease.
If you enter into a capital lease, the IRS views it as the purchase of new equipment. Because the farmer is deemed to have purchased the equipment, the traded equipment is eligible for like-kind exchange treatment. This results in no recognized gain or loss. However, because you have purchased the equipment, you must depreciate it — not expense the lease payments.
How we can help
As the popularity of leasing continues to grow, understanding the tax consequences is critical. Leasing can be used as a powerful tax planning tool and may provide more benefits than depreciation. Prior to purchasing or leasing equipment, explore your options with a tax professional.