For tax years starting in 2018, the Tax Cuts and Jobs Act (TCJA) provides new and improved tax incentives for buying new and used business equipment. But leasing still offers benefits for some taxpayers. Here are some important considerations when deciding whether to buy or lease equipment.
The primary advantage of owning fixed assets is that you're free to use them as you see fit. When you own equipment that won't become obsolete, you should get your money's worth from the purchase over time. This is especially true for assets — such as a desk or drill — that tend to have a long useful life and aren't affected by technology changes.
In addition, from a tax perspective, the Section 179 deduction and first-year bonus depreciation privileges can provide big tax savings in the first year an asset is placed in service. These tax breaks were dramatically enhanced by the TCJA — enough so, that you may be convinced to buy assets that your business might have leased in the past.
Sec. 179 expensing. This tax law provision provides a current deduction for the cost of qualified new or used business property that's placed in service in the tax year. The maximum Section 179 deduction has been doubled from $500,000 under prior law to $1 million under the TCJA for qualified property placed in service in tax years beginning in 2018. The Sec. 179 deduction is available for most types of equipment, ranging from heavy machinery to computers and desks. Software and qualified real property expenditures can also qualify for the Sec. 179 deduction privilege.
The Sec. 179 deduction is limited to the amount of a taxpayer's business income calculated before the deduction and is phased out if qualified asset additions exceed the phaseout threshold. The TCJA increased the phaseout threshold from $2.03 million for tax years beginning in 2017 to $2.5 million for tax years beginning in 2018. This increase provides plenty of leeway for most small businesses.
Bonus depreciation. A business can claim a first-year bonus depreciation deduction for the cost of qualified property, which includes most types of equipment used by small business owners. In fact, the same property may qualify for both the Sec. 179 deduction and bonus depreciation. If so, bonus depreciation is preferred for assets placed in service by December 31, 2022.
Under the TCJA, bonus depreciation has been extended to include used property. The amount of the deduction has also been doubled from 50% under prior law to 100% under the TCJA for qualified property placed in service from 2018 through 2022. For tax years starting in 2023, bonus depreciation deductions will be phased out based on the following schedule:
Bonus depreciation is scheduled to expire at the end of 2026, unless Congress decides to extend it.
These two tax breaks can be a powerful combination: Many businesses will be able to write off the full cost of most equipment in the year it's purchased. Any remainder is eligible for regular depreciation deductions over IRS-prescribed schedules.
Important note: Other rules and restrictions may apply, including limits on annual deductions for vehicles and restrictions on "listed property" (such as TVs).
The primary downside of buying fixed assets is that you're generally required to pay the full cost upfront or in installments, although the Sec. 179 and bonus depreciation tax benefits are still available for property that's financed.
If you finance a purchase through a bank, a down payment of at least 20% of the cost is usually required. This could tie up funds and affect your credit rating.
Important note: If you decide to finance fixed asset purchases, be aware that the TCJA limits interest expense deductions (for businesses with more than $25 million in average annual gross receipts) to 30% of adjusted taxable income (ATI) for tax years starting in 2018. Any excess can be carried over indefinitely. In addition, when computing ATI for tax years beginning in 2022 and beyond, deductions for depreciation, amortization and depletion won't be added back. This transition rule could significantly increase ATI for a business, resulting in a lower interest expense deduction limitation after 2021. Be aware that this complicated provision is subject to several exceptions. Contact your tax advisor about your situation.
In addition, when you own an asset, you run the risk that it could quickly become outdated or obsolete. It may be difficult to unload the equipment at a reasonable price, not to mention the headache of trying to sell it. For example, if you buy computers costing $5,000 today, they could be worth only $1,000 or less in just three years.
From a cash flow perspective, leasing can be more attractive than buying. But the tax benefits for leasing may not be as valuable. And you don't own equipment at the end of the lease term. So, if you want to replace the asset when the lease is up, you'll face the leasing vs. buying decision all over again. But this could be a good thing if an asset is likely to become obsolete by the end of the term.
The main advantage is the upfront cost savings. For example, if you lease equipment with a five-year useful life, the first-year expense may be only 20% of the total asset cost. Typically, you won't have to come up with a down payment for a leased asset (although there are exceptions, including some vehicle leases). In turn, the funds you retain by leasing an asset, rather than buying it, can be used for other purposes and to improve business cash flow.
Of course, your business is entitled to a tax deduction for annual lease payments, but you miss out on Sec. 179 and bonus depreciation deductions. Although there are some nuances, lease payments are generally tax deductible as "ordinary and necessary" business expenses. As with ownership of vehicles, annual deduction limits may apply.
Beyond taxes, leasing may be a more viable option for companies with questionable credit ratings, limited access to bank financing or limited cash reserves. And, in today's competitive leasing market, leases with favorable terms are common.
Important note: For many years, U.S. Generally Accepted Accounting Principles (GAAP) have provided a financial reporting incentive for certain types of leasing arrangements. See "Add New Accounting Rules to the Mix" at right. However, new accounting rules go into effect in 2019 for calendar-year public companies and 2020 for calendar-year private companies that bring leases to the lessee's balance sheet. So, lease obligations will show up as liabilities, similar to purchased assets that are financed with traditional bank loans.
Leasing does have drawbacks, however. Over the long run, leasing an asset may cost you more than buying it, because you're continually renewing the lease or acquiring a new one. For example, a top-of-the-line computer that normally costs $5,000 might run you $200 a month over a three-year lease term, or $7,200. After all, leasing companies have to make profits, too.
Leasing also doesn't provide any buildup of equity. At the end of the lease term, you get nothing back, whereas buying might result in some return on a resale.
What's more, when you lease, you're generally locked in for the entire lease term. So, you're obligated to keep making lease payments even if you stop using the equipment. In the event the lease allows you to opt out before the term expires, you still may be forced to pay an early-termination fee.
When deciding whether to lease or buy a fixed asset, there are a multitude of factors to consider, with no universal "right" or "wrong" choice. With assistance from your tax and financial advisors, you can take the approach that best suits your circumstances.
New accounting rules issued by the Financial Accounting Standards Board (FASB) will require companies that follow U.S. Generally Accepted Accounting Principles (GAAP) to report lease obligations on their balance sheets. This change is intended to improve transparency about current off-balance-sheet leasing activities.
Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), will require companies that lease fixed assets (lessees) to recognize all leases with terms of more than 12 months on their balance sheets, regardless of their classification as capital or operating leases. Specifically, a business must report a right-to-use asset and a corresponding liability for the obligation to pay rent, discounted to its present value by the rate implicit in the lease or the lessee's incremental borrowing rate.
Lessees also will be required to make additional disclosures to help users of financial statements better understand the amounts, timing and uncertainty of cash flows related to leases. They must disclose qualitative and quantitative requirements, including information about variable lease payments and options to renew and terminate leases.
In some cases, businesses might consider buying property they previously would have leased. Under the new accounting rules, the balance sheet impact will be similar for leased and purchased items. In other words, companies can no longer bury operating lease obligations in their footnotes.
The new accounting rules for leases apply to public companies with fiscal years beginning after December 15, 2018, and private companies with fiscal years beginning after December 15, 2019.
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