Lease vs. Purchase of Machinery

Warren Lee, Professor Emeritus Dept. of Agricultural, Environmental, and Development Economics, The Ohio State University

Introduction

Leasing or purchasing of machinery and equipment represent alternative ways for farm operators to acquire assets for agricultural production. Leasing has increased in popularity with agricultural producers. Manufacturers and financial institutions view leasing and selling equipment as alternative means to generate business. By comparing the net present value of the after-tax costs, farmers can determine the least expensive way to acquire machinery or other assets in the farmer’s specific situation. Key factors in the lease vs. purchase decision are the interest rate on loans, lease payments, the taxpayer’s marginal tax rate, and the taxpayer’s after-tax discount rate that reflects the time value of money. An important factor in this decision process is the acquisition of new technology and how rapidly that technology may become obsolete or of it is needed for a specific length of time.

Lease or Purchase? Look at the Contract Details

Some so called lease contracts must be treated as conditional sales contracts for tax reporting purposes. If the agreement is treated as a conditional sales contract the payments cannot be deducted as rent. Instead, the payments must be capitalized to determine the cost of the property and this cost is recovered through depreciation. You can also deduct interest, repairs, insurance and other expenses associated with the equipment. 

Whether an agreement is a conditional sales contract depends on the intent of the parties. No single test applies, but in general, the agreement may be considered a conditional sales contract if any of the following is true.

• The agreement applies part of each payment to an equity interest in the property.
• You get title to the property after making a stated amount of required payments.
• The amount you pay over a short time period 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 the option to buy the property at a nominal price compared to the market value of the property, or compared to the total amount you have to pay under the agreement.
• The agreement designates part of the payments as interest, or part of the payments can be easily recognized as interest. 

Interpretation

It should not be concluded from this example that leasing is always preferred to purchasing. For example, the foregoing analysis of the purchase option did not include the possibility of using the Section 179 expense deduction. Suppose that Mary purchased the tractor and claimed half of the purchase price ($50,000) under the Section 179 election. As shown in Table 3 (below), the present value of the purchase alternative with $50,000 Section 179 is $61,549, or $877 less than the leasing alternative. With a constant tax rate, the Section 179 expense deduction taken now has a higher present value than equivalent depreciation deductions taken later. The tax savings from the Section 179 election also significantly reduce the initial cash outlay from $30,000 to $14,500.

Table 3. Purchase of a $100,000 Tractor with a 5-Year Fully Amortized Loan with 30% Down, 7% Interest Rate: Sale in Year 10 for $15,000, $50,000 Section 179 Election

Year (1)	Payments (2)	Interest Expense (3)	Depreciation/ Section 179 (4)	Adjustment for Taxes (5)	Net After-Tax Cash Flow (6)	8% Discount Factor (7)	P. V. of Net Cash Flow (8)
0	30000		50000	15500	(14500)	1.0000	(14500)
1	17072	4900	5355	3179	(13893)	0.9259	(12864)
2	17072	4048	9565	4220	(12852)	0.8573	(11018)
3	17072	3136	7515	3302	(13770)	0.7938	(10931)
4	17072	2161	6125	2569	(14503)	0.7350	(10660)
5	17072	1117	6125	2245	(14827)	0.6806	(10091)
6			6125	1899	1899	0.6302	1197
7			6125	1899	1899	0.5835	1108
8			3065	950	950	0.5403	513
9						0.5002
10					12300*	0.4632	5697
Totals	115360	15362	100000	35763	67297		(61549)

*After tax proceeds from sale of tractor = $15,000 - (15,000 x 0.18) = $12,300

Trade-in value becomes another issue in the lease vs. buy decision. If the replacement property is purchased, the transaction is treated as a like-kind exchange in which any gain or loss on the trade-in will not be recognized until you sell or otherwise dispose on the new asset. The trade-in of an asset for a lease of a like-kind asset does not qualify as a like-kind exchange. Gain or loss must be recognized on the disposition of the old asset. Like-kind treatment favors the purchase alternative. Conversely, rapid changes in technology may favor the lease arrangement due to decreased service life of some technologies.

Ultimately, the lease vs. buy decision is influenced by a number of factors which cannot be analyzed with manual calculations. The University of Illinois farmdoc website contains excellent software for analyzing lease vs. purchase and other business decisions. See www.farmdoc.illinois.edu and look under FAST tools to find downloadable programs. 

IRS Publications

For more information on or to access Schedule E, Schedule F, Form 1065, or Form 4835, visit the IRS website at www.irs.gov and click on “Forms and Publications.” Then click on “Publication number” under “Download forms and publications by.” Type the publication number in the find box to search for the publication. Publications may be viewed online or downloaded by double clicking on the publication.

Additional Topics

This fact sheet was written as part of Rural Tax Education, a national effort including Cooperative Extension programs at participating land-grant universities to provide income tax education materials to farmers, ranchers, and other agricultural producers. For a list of universities involved, other fact sheets and additional information related to agricultural income tax please see RuralTax.org.

Published July 2012

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