Purchasing vs. Leasing

Depreciation generally may be claimed by the owner of a capital asset. If you lease your equipment instead of purchasing it, you can't depreciate the equipment. However, you will generally be able to deduct the lease payments you make, at the time that you make them, which can result in a larger tax benefit than you'd get if you bought the equipment outright.

Warning In some cases, what appears to be a lease might be treated as a sale for tax purposes under IRS rules.

To make an informed decision about whether purchasing or leasing will be more advantageous in your particular situation, and especially for major equipment purchases, we recommend that you (or your accountant) should perform a cash flow analysis and comparison of what the payments and tax savings would be under a sale or a lease.

If you lease property that is used for both business and personal purposes, you must prorate the lease payments and deduct only the portion of the lease that corresponds to your business use percentage.

Inclusion amounts for listed property. If, instead of purchasing it, you lease your business equipment, such as your car, computer system, audio/visual equipment, or other listed property you may have to include an additional amount known as the "inclusion amount" in your gross income. This extra amount is intended to place you on the same financial footing as someone who has purchased similar equipment and can only deduct the depreciation, which is typically less than your lease payments would be.

Warning If you lease a car, you must calculate an inclusion amount for every year you deduct lease payments.

If you lease some other type of listed property, you only need to calculate an inclusion amount if your business usage of the property drops to 50 percent or less for a year. The inclusion amount is added to your income only for that year.

Example This could easily happen, for instance if you have not claimed the home office deduction, but have been leasing a computer predominantly for business at home, and then you find that your family is using the computer more than you!

To calculate your inclusion amount, you need to know the fair market value of the item on the first day of the lease term. Alternately, if the capitalized cost of the item is specified in the lease, you must treat that amount as the "fair market value."

Planning Tools You can use this inclusion amount worksheet and its tables to calculate your inclusion amount.

The final result must be included as "other income" on Line 6 of your Schedule C.

There is an exception to this rule if the lease term began within the last nine months of your tax year and extends into the next year, and you did not use the property more than 50 percent for business in the first year of the lease. In that case, you would calculate your average business use percentage for the first and second calendar years and the percentage amount for the first year. The inclusion amount would be added to your income for the second year, not the first.

True leases vs. financial leases. In certain situations, the IRS may deny your deduction of lease payments if it audits your return and concludes that your lease is not in reality a true lease, but a financial lease, which can be treated as an installment or conditional sale. To understand why the IRS would even care whether you characterize your acquisition as a lease or a purchase, consider the following example:

Example Jiffy Company is interested in a piece of equipment that sells for $25,000. However, instead of purchasing the equipment, Jiffy negotiates to lease the equipment for three years at an annual rent of $8,500. The lease grants Jiffy the option to purchase the equipment at the end of the lease for $2,400. The fair rental value of the equipment is only $3,000. Why would Jiffy and the leasing company do this? From Jiffy's perspective, leasing the equipment allows it to effectively recover the equipment's cost over three years via its deductions of the rental payments. If it had purchased the equipment, it likely would have recovered the cost over five years via depreciation deductions. And the IRS really frowns upon the improper acceleration of deductions. From the lessor's perspective, leasing the equipment allows it to spread its recognition of income over the three-year lease period. The improper deferral of income is another thing the IRS dislikes. Furthermore, the lessor would be able to claim depreciation deductions with respect to the equipment while it is being leased and thereby reduce its current income even more.

If the IRS does recharacterize your lease as a sale, your rental payments will not be deductible. Instead, you'll be entitled to depreciation deductions as the owner of the property for tax purposes. Moreover, a portion of your rental payments, which the IRS effectively recharacterizes as being installment payments on a purchase price, will likely be considered interest that you can currently deduct.

The leasing transaction in the example above is one that the IRS would likely recharacterize. What types of factors attract the IRS's attention? Here are some examples:

• A portion of your rental payments establishes equity in the leased property.
• You acquire title to the property after paying a specified amount of rent.
• Your rental payments are made over a relatively short period of time and are inordinately large in comparison to the amount required to purchase the property.
• Your rental payments substantially exceed the fair rental value of the property.
• You can acquire the property under a purchase option for a price that is nominal in relation to the property's value at the time you can exercise the option or that is nominal in comparison to your total payments under the lease.
• A portion of your rental payments is specifically designated as being interest or is readily recognizable as being the equivalent of interest.

If any of these factors describe an equipment lease you're preparing to enter, you should proceed with caution to avoid interest and penalties if the IRS recharacterizes the transaction. If you have any doubt as to how the IRS may view the lease, have your accountant or lawyer review the agreement.