Businesses periodically need to add equipment to grow their operations and replace outdated assets. When this need arises, business owners may ask their financial advisors whether it’s better to buy or lease those assets. There’s no universal “right” choice. And recent changes to the lease accounting and federal income tax rules have muddied the waters. Here are some pros and cons to factor into this critical investment decision.
Basics of buying
There are many reasons business owners prefer to buy equipment, rather than lease it. The primary advantage of owning 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 a 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 Tax Cuts and Jobs Act (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 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.
For qualifying property placed in service in 2021, the expensing limit is $1.05 million. The break begins to phase out dollar for dollar when asset acquisitions for the year exceed $2.62 million.
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. For qualified assets placed in service through December 31, 2022, bonus depreciation is 100%. For tax years starting in 2023, bonus depreciation deductions will be gradually phased out. 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.
Other rules and restrictions may apply, including limits on annual deductions for vehicles and restrictions on “listed property” (such as TVs).
Drawbacks of purchases
The primary downside of buying equipment is that it could quickly become outdated or obsolete. Outdated equipment may be difficult to unload at a reasonable price, not to mention the headache of trying to sell it.
In addition, when you own an asset, you’re generally required to pay the full cost upfront or in installments. (However, 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.
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.
Additionally, 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.
Lowdown on leasing
A key advantage of leasing 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.
From a cash flow perspective, leasing can be more attractive than buying. But 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.
Changes to GAAP
For many years, U.S. Generally Accepted Accounting Principles (GAAP) have provided a financial reporting incentive for certain types of leasing arrangements. However, the waters have been muddied by updated accounting rules that went into effect in 2019 for calendar-year public companies and will go into effect in 2022 for calendar-year private companies.
Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842)
, requires companies that follow GAAP 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.
Under the new accounting rules, the balance sheet impact will be similar for leased and purchased items. In some cases, the changes may cause businesses to consider buying property they previously would have leased.
Pitfalls of leasing
There are additional drawbacks to leasing for business owners to factor into their decisions. For example, over the long run, leasing an asset may cost 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. Contact your CPA to help determine the appropriate course of action for your situation.