Tax Implications of Leasing
Under a typical equipment lease, you generally are entitled to currently
deduct your rental payments if you use the leased property in your business.
However, you need to be aware that, in certain situations, the IRS may deny
rental deductions if it audits your return and concludes that your lease is in
reality 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:
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 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
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
- A portion of your rental payments establishes equity in the leased
- 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
- Your rental payments substantially exceed the fair rental value of the
- 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
- 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.