Most segments of agriculture are experiencing financial stress. But that doesn't stop equipment from needing to be replaced. With the low commodity prices and tax law changes, many clients have asked about purchasing or leasing equipment. Because of high interest rates and the fear that they might go up, purchasing equipment on credit is becoming less attractive. But is leasing any better since the price of equipment increases every year? One thing is certain: There is much confusion.

There are two types of leases: operating and capital. An operating lease is what most people think of when they hear the term "lease." You make payments for a period and have the option to purchase the equipment at the end of the lease for its residual or fair market value. Once purchased, the lessee can depreciate the asset with basis equal to the amount they paid to acquire the asset at the end of the lease.

When a lessor/lessee gets too aggressive with leasing terms, the IRS may deem it to be a capital lease. This is because the farmer essentially has purchased the equipment and makes "lease" payments instead of principal and interest. If you enter a capital lease, the IRS views it as the purchase of new equipment. And, because you have purchased the equipment, you must depreciate it, not expense the lease payments.

So, why is this so difficult? One area where lessors and lessees get tripped up is the ambiguity in residual value (purchase prices at the end of the lease). There is no clear guidance, but the IRS likes to see at least 20% residual value. However, the real test is the economic substance of the transaction: Will the lessee purchase the property at the end of the lease? To put it simply, the residual value must be high enough to make the lessee think twice about purchasing the equipment.

Sometimes, farmers use operating leases as a tax strategy. For example, you want to purchase a multipurpose farm shed. That would be a 20-year asset. Farm income is down, so you don't want to take bonus depreciation and create a net operating loss (since that does not reduce self-employment tax in future years). One option is to do a sale-and-leaseback for seven to 10 years. You can transform a 20-year asset into lease payments over seven to 10 years. The result is higher lease expense versus traditional depreciation deduction. At the end of seven to 10 years, you purchase out the shed and depreciate it. Note that there is a drawback: Since you previously used the shed, you are not eligible for bonus depreciation when you purchase it from the bank or leasing party.

So, what is right for you? With the depressed commodity prices and high interest rates, many people are exploring leasing. Farmers can write off lease payments and turn in the equipment at the end of the lease. However, farmers are writing off payments over two or three years rather than taking Section 179 or bonus depreciation in the year of purchase. But beware of the fine print -- read lease agreements carefully to thoroughly understand the terms of the obligations.

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DTN Tax Columnist Rod Mauszycki, J.D., MBT, is a tax principal with CLA (CliftonLarsonAllen) in Minneapolis, Minnesota. Read Rod's "Ask the Taxman" column at https://www.dtnpf.com/…. You may email Rod at taxman@dtn.com.

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