Tighter credit continues to inspire dealers, banks, and leasing companies to entertain writing leases on late-model, lower-hour used equipment. In fact, some financial outlets now offer to buy your equipment and then lease it back to you in what is called sale leaseback. This leasing option has increased in popularity as a means to enhance cash flow. A sale leaseback works like an equity loan on your land. If you own equipment, you can use that asset to receive money and pay it back over a set period of time (typically three to five years).
If depreciation has already been taken on that equipment, you could opt for a conditional type of sale leaseback. The most popular conditional sale option is a purchase upon termination (PLB). With this transaction, you maintain tax ownership of the asset and continue to depreciate the asset during the life of the PLB agreement.
As a result, there is no gain recognized, and you benefit from lower payments than with a loan because the lease has a balloon-like residual. When the lease ends, you have the option of buying the equipment for its lease residual value.
Just Another Form of Financing
Whether a lease is employed to obtain new or used iron, Amy Weum of CoBank Farm Credit Leasing stresses that leasing is just another form of financing. Whether you’re considering a loan or a lease, take the time to ask questions and understand the terms of the agreement to ensure it aligns with your operation’s financial goals. Absolutely consult with your accountant or tax adviser to discuss your specific tax circumstances and cash flow requirements.
Generally, the rules of leasing hold true whether that iron is new or used, says Tina Barrett, who is a University of Nebraska economist and executive director of Nebraska Farm Business Inc. “It’s important you consider the pros and cons of this decision and that you consider what effect lease vs. purchase decisions will have on the tax return,” she says.
Reducing debt (by leasing) certainly can improve the debt-to-asset ratio for a farm that has equity in assets. “We 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 may depend on the individual.”
Leasing also keeps you from having an asset that depreciates. “One argument 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.”
Lower Payments
A lease can also lower payments and money required up front. Compared with the 10% to 20% down payment required on an installment loan, leasing generally requires only the first two monthly payments, which are calculated by the lender based on an assumption of how much the equipment will be worth at the end of the lease. That figure (called the residual value) is subtracted from the retail price. The remainder is spread over the length of the lease term in monthly payments that tend to be generally lower than those on an installment loan.
Most financial institutions that furnish equipment with a lease promote tax savings as the main reason you should lease. However, Barrett says, “as a tax preparer, I list taxes as the top con.”
Tax law certainly allows that 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 (often called an equipment finance contract, or EFC) as defined by the IRS.
“In the leases I see, there are many factors that trip the IRS rules. The most common is 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.”
Beyond tax considerations, the main difference between a true lease and an EFC is that with a true lease, you make payments for a set period of time (often two to five years). At the end of the contract, you may walk away from equipment or have the option to purchase it for a percentage (often 10%) of the original amount.
An EFC has a payment schedule similar to a true lease but is treated as a conditional sale contract by the IRS. This means you are considered the owner of the machine, so that machine is placed on the depreciation schedule. Payments made to the lease company with an EFC must be divided into interest and principal; only the interest portion is tax deductible. Also, since the EFC is not being taxed as a true lease, the final buyout price can be quite variable.
