When I recently asked a business owner why he decided to lease instead of buy a piece of equipment, I got a blank look and an “I don’t know, it just sounded right” response. While gut feel can play a necessary part in decision-making, some underlying guidelines could be helpful when your gut is on vacation.
Leasing has grown in popularity due to some key advantages over buying.
- 100% financing at fixed rates. When cash is scarce, the minimal to no down payment can be helpful. And since lease payments are often fixed, you are protected against inflation and increases in the cost of money. Compared to a traditional bank loan (for buying a piece of equipment) where a only a portion of the total cost can be financed as well as the likely floating rate, a lease can offer a locked in payment with little up front cash.
- Protection against obsolescence. This can be especially useful in the case of computers, but the risk of obsolescence for any fast-changing technology is now transferred to the lessor instead of you.
- Flexibility. Lease agreements may have more flexible terms than other debt arrangements. Lease term can be very short (if you only need it for a specific project) to the entire economic life of the asset. The lease payments can be level from year to year or may vary depending on the prime interest rate, the CPI, the amount of usage or sales, or another factor.
- Tax advantages. If you are in a low tax bracket, leasing may help you reap tax benefits otherwise unavailable. If you don’t have enough taxable income to take advantage of accelerated depreciation deductions, then at least you can deduct the lease payments. On the books, a leased asset does not need to be claimed as an asset unless it obeys certain criteria (see operating vs capital lease below). For tax purposes, however, you can capitalize and depreciate the leased asset.
- Off-balance-sheet financing. You may have heard of this terms but not known what it really means. Off-balance sheet financing means that certain types of leases don’t add debt on the balance sheet, which means your liabilities are lower, which means your debt to equity ratio looks better. If you’re trying to increase your borrowing capacity, a lower debt to equity ratio could be helpful. Capitalization of leases should occur, however, if the lease transfers substantially all of the benefits and risks of property ownership, and the lease is noncancelable.
Now, let’s check out the advantages of buying.
- Asset ownership. You have equity in an asset, which is a good thing if the item has a long useful life and won’t become obsolete anytime soon. You also have the option to modify and upgrade the asset as you wish, as well as decide upon its maintenance schedule.
- Section 179 tax incentive. If you have significant taxable income to benefit from this, and depending on the cost and type of asset, you may be able to deduct the entire cost (up to $500,000 for 2014) through the Section 179 depreciation deduction. So if you are in a 30% tax bracket and you purchase a $200,000 machine, the effective cost of the machine would be $140,000 with this deduction. Moreover, if your equipment is over $500K, you may still be able to deduct 50% of the amount over $500K and under $2 million through bonus depreciation. This may not always be approved by policymakers to continue to the next tax year but it is likely this will continue into 2015.
- Accelerated depreciation. Again, you can use an accelerated depreciation schedule to write off the a bigger chunk of the depreciation earlier in the life of the asset, decreasing taxable income in these early years.
- Less expensive. If you’re not cash-strapped, then buying a piece of equipment outright will often be less than the present value of the lease payments.
- Flexibility of use. Since you’re the owner, you can use the machine as much or as little as you like, without any penalties. And if you decide you no longer need the equipment, you can sell it without the possibility of early termination fees inherent in many leases.
How to you decide? It comes down to what you are able to afford, the useful life and potential obsolescence of the asset, and the net cost and benefit.
- Determine the available tax breaks (for the tax year of purchase, as the limits and availability can change) including Section 179, bonus depreciation, and regular depreciation.
- Determine the anticipated resale value at the end of the asset’s useful life at your firm.
- Determine the cost of financing, if any. Can you afford the interest payments? Or can the money saved from lower lease paymnts be used to invest elsewhere with a higher return?
- Determine any upfront fees in either case, buying or leasing.
Need more help in deciding? Reach out and let us give you a helping hand!