|The Tax Cuts and Jobs Act (TCJA) provides new and improved tax incentives for buying new and used business equipment for tax years starting in 2018. Some taxpayers may still see benefits from leasing though. When deciding which way to go, here are some important considerations.
Pros of Buying
The primary advantage of purchasing and owning fixed assets is that you can use them however you see fit. Especially with equipment that is not going to become obsolete, you should get your money’s worth from the purchase over time. Think of assets like a desk or a drill that have a long useful life and won’t be affected by technology changes.
From a tax perspective, the Section 179 deduction and first-year bonus depreciation privileges can also provide big tax savings in the first year an asset is placed in service. The TCJA dramatically enhanced these tax breaks, to the degree that you may find buying assets you previously leased makes more sense now.
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 applicable for most types of equipment, 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. Businesses can claim a first-year bonus depreciation deduction for the cost of qualified property, including most types of equipment used by small business owners. It’s entirely possible the same property may qualify for both the Sec. 179 deduction and bonus depreciation. If this is the case, bonus depreciation is preferred for those assets placed in service by December 31, 2022.
Bonus depreciation has been extended to include used property under the TCJA. 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 according to the following schedule:
· 80% for property placed in service in 2023,
· 60% for property placed in service in 2024,
· 40% for property placed in service in 2025, and
· 20% for property placed in service in 2026.
Unless Congress decides to extend it, bonus depreciation is scheduled to expire at the end of 2026.
Combining these two tax breaks can be powerful: Many businesses will be able to write off the full cost of most equipment in the year it’s purchased. The remainder, if any, 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).
Cons of Buying
There can be downsides to buying fixed assets as well. 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.
Should you decide to finance a purchase through a bank, a down payment of at least 20% of the cost is often required. This may tie up funds and affect your credit rating.
Important note: If you do decide to finance the purchase of fixed assets, 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. Plus, when computing ATI for tax years beginning in 2022 and beyond, deductions for depreciation, amortization, and depletion will not be added back. This transition rule may significantly increase ATI for a business, leading to 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.
Another drawback to purchasing is that you run the risk that it could quickly become outdated or obsolete. At that point, it may be difficult to sell the equipment at a reasonable price, not to mention the headache of finding potential buyers. Items like computers can depreciate quickly, losing their worth drastically after purchase.
Pros of Leasing
Leasing can be more attractive than buying from a cash flow perspective. But the tax benefits associated with leasing may not be as valuable. And at the end of the lease term, you don’t own anything. So should you want to replace the asset when the lease is complete, you face the same lease vs. buy decisions again. Of course, if an asset is likely to become obsolete before the end of the term, this could be a good thing.
Upfront cost savings are the main advantage of leasing. As an example, if you lease equipment with a five-year useful life, the first-year expense may be only 20% of the total asset cost. Usually, you won’t have to come up with a down payment for a leased asset (although there are exceptions, including some vehicle leases). With the money you retain by leasing rather than buying, you can improve business cash flow or use for other purposes.
There are tax deductions for annual lease payments but you won’t be able to take advantage of Sec. 179 and bonus depreciation deductions. Lease payments are usually tax deductible as “ordinary and necessary” business expenses, although there are nuances to that. Annual deduction limits may apply, as they do with vehicle ownership.
Leasing may also be a more viable option for companies with questionable credit ratings, limited access to bank financing, or limited cash reserves. Leases with favorable terms are common in today’s competitive leasing market.
Important note: For many years, U.S. Generally Accepted Accounting Principles (GAAP) have provided a financial reporting incentive for certain types of leasing arrangements. However, new accounting rules will 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.
Cons of Leasing
There are drawbacks to leasing as well. Over time, leasing an asset may cost more than buying it, whether you’re renewing a lease or acquiring a new one. For instance, a top-of-the-line computer that would cost $5,000 to buy might be $200 a month over a three-year lease term—totaling $7,200.
A lease also keeps you from building up any equity. At the end of the lease term, you have nothing, whereas buying might result in some return on a resale.
And when you lease, you’re usually locked in for the entire lease term. So you’ll be obligated to continue making lease payment even if you aren’t using the equipment. In the event you are allowed to opt out before the end of the lease, there may be an early-termination fee.
As with many such decisions, there are many factors to consider with no single “right” or “wrong” choice. Your circumstances may best suit either buying or leasing; with assistance from your tax and financial advisors, you can make that decision with confidence.