By Mark C. Battersby, “Money Talk, Rural Builder magazine
Buy or lease? That is a question facing many rural building businesses, even as credit becomes more readily available. While virtually everyone understands the simplicity of buying, leasing is far more complicated. Deciding the best strategy is a tough move for anyone and, obviously, there is no one correct answer that fits every situation, nor every building business.
Equipment leasing is generally a loan in which the lender buys and owns equipment and then “rents” it to a building business at a flat monthly rate for a specified number of months. At the end of the lease period, the business may purchase the equipment for its fair market value (or for a fixed pre-determined amount), continue leasing, lease new equipment or return it.
Although lease financing is generally more expensive than bank financing, in most instances it is more easily obtained. One recent survey by the Equipment Leasing Association found that among the Small Business Administration’s State Small Business Contest winners, almost 70 percent leased equipment.
Advantages of ownership
The top reasons given by small business owners for leasing include the ability to have the latest equipment; consistent expenses in budget management; help in managing company growth; and no down payment.
Leasing offers real advantages, including reduced cash outflows and greater control. But that’s not all. A short list of leasing advantages includes:
• Conventional bank loans usually require more money up-front than leasing.
• Leasing generally requires only one or two payments up-front in lieu of the substantial down payments often required to purchase equipment.
• Unlike some financing options, leasing offers 100 percent financing. That means a builder or contractor can acquire essential operating equipment and begin using it immediately to generate revenues with no money down.
Best of all, the full amount of the equipment, as well as service, shipping costs and maintenance can be included in the lease. This spreads the cost over the term of the lease, freeing up cash flow for the building business now, when needed.
• Leasing provides a hedge against technology obsolescence by allowing building businesses to upgrade their equipment at the end of the leasing term.
• An operating lease is not considered long-term debt or liability; it does not show up on the business’s financial statements. This makes the business more appealing to traditional lenders down the road or when needed.
• Operating leases are generally treated as fully deductible business expenses. Your tax professional should be consulted to determine what percentage of other types of leases can be deducted.
Ownership and tax breaks make buying business equipment appealing, but high initial costs mean this option isn’t for everyone. Among the advantages of buying equipment:
• Ownership: The most obvious advantage of buying business equipment is that you gain ownership of it. This is especially true when the property has a long useful life and is not likely to become technologically outdated in the near future, such as office furniture or farm machinery.
• Tax incentives: Imagine an immediate expensing write-off that, unlike Section 179, is not limited to use by smaller building businesses nor capped at a certain dollar level. The 2010 Tax Relief Act boosts 50 percent bonus depreciation to 100 percent for qualified investments made after September 8, 2010 and before January 1, 2012. The new law also allows 50 percent bonus depreciation for qualified property placed in service after December 31, 2011 and before January 1, 2013.
Last fall’s Small Business Jobs Act also increased the Section 179, first-year expensing dollar and investment limits to $500,000 and $2 million, respectively, for 2010 and 2011. The Tax Relief Act provides for a $125,000 dollar limit and a $500,000 investment limit for tax years beginning in 2012 and “sun setting” after December 31, 2012.
Disadvantages of ownership
• Higher initial expense: For some builders and contractors, purchasing needed equipment may not be an option because the initial cash outlay is too high. Even if the business plans to borrow the money and make monthly payments, most banks require a down payment of around 20 percent. Borrowing money may also tie up lines of credit, and lenders may place restrictions on the building operation’s future financial operations to ensure the loan will be repaid.
• Obsolete Equipment: Ownership is perhaps the biggest advantage to buying business equipment, although it can also be a disadvantage. Purchasers of high-tech equipment run the risk the equipment that may become technologically obsolete, and they may be forced to reinvest in new equipment long before planned. Certain business equipment has very little resale value. A computer system that costs $5,000 today, for instance, may be worth only $1,000 or less three years from now.
The tax benefits associated with a lease are also important. Whether the ever-vigilant IRS treats a leasing transaction as a lease, or treats it as a purchase, determines who will be entitled to deductions for expenses such as depreciation, rent and interest expenses.
For most leases, the rules for determining whether a transaction is a lease or a purchase evolved from a series of court decisions and IRS rulings. Generally, when it comes to determining who is the owner of the property for tax purposes, the IRS looks to the “economic substance” of the transaction – how it is structured and works – not how the parties involved characterize it.
There is no time limit on leasing. In fact, leasing is effective where a building business has already purchased equipment. These transactions, known as sale-leasebacks, are usually available for equipment purchased within the past 90 days. Sale-leasebacks may also be used to legitimately shift the tax benefits from the building business to its owner or shareholders.
Every builder and contractor can analyze the costs of leasing versus purchase with a so-called discounted cash flow analysis, comparing the cost of each alternative by considering the timing of the payments, tax benefits, interest rates on a loan, the lease rate, and other financial arrangements. Unfortunately, while this sort of analysis is useful, the lease/buy decision can’t be made solely on cost analysis figures.
Generally, building businesses with a strong cash position and good financing options can often buy needed equipment outright, or they can borrow to acquire equipment with a long operating life. If obsolescence is a concern, a short-term operating lease often provides the biggest advantage and the most flexibility.
If cash flow is an issue and the equipment must remain operable for longer periods, a long-term capital lease, with a final residual payment will result in lower monthly payments plus a purchase option. However, short-term savings may result in higher costs over the entire leasing period. This is especially true with a finance lease where the user can purchase the equipment at the end of the lease. The building business may end up paying more over the long term. Obviously, it pays to determine any end of lease costs beforehand.
Furthermore, although taxes play a role in whether to lease or to purchase, they should not be the deciding factor either. Since a startling eight out of ten businesses lease some equipment, would your building business reap the long-term benefits of a lease?
Mark Battersby is an expert in tax and financial matters. With more than 30 years experience in small busines sissues, he lectures and writes extensively on business topics. Contact him at 610-789-2480 or MEBatt12@Earthlink.net.