Lease vs. Buy: How to Finance New Equipment
posted Nov 13, 2017 by Claire Iacobucci, CPA in the Business Blog
KLR’s 2017 Manufacturing Industry Outlook report found that nearly 40% of respondents expect to upgrade information technology equipment, and roughly one-third plan to invest in automated equipment. But, when it comes to funding these purchases, many businesses won’t have enough cash on hand to buy them outright.
Are you planning to buy new equipment over the next 12 months? Here are two financing alternatives that may help achieve your capital investing goals.
Manufacturers often finance equipment purchases with conventional term loans. Debt financing is especially attractive today, because interest rates are relatively low compared to historical interest rates. The U.S. prime rate is currently 4.25%. By comparison, its 50-year high was 21.5% in 1980. The median prime rate from 1955 to present is 9%.
Under existing tax law, businesses can deduct depreciation expense and interest costs from term loans on their federal income tax returns. But the tax break for interest expense may be reduced or eliminated under tax reform proposals that are being discussed by Congress.
In exchange for interest deductions, some lawmakers have proposed allowing companies to deduct the full cost of equipment in the first year the asset is placed in service, even if it’s financed over, say, five or seven years. However, Congress hasn’t made any final decisions regarding full expensing or the deductibility of interest expense.
Typically, lenders expect businesses to make a 20% or 30% down payment for term loans. If you don’t have money for a down payment, consider leasing (below).
In general, an equipment lease is a financing arrangement in which an outside company (the lessor) owns equipment and leases it to you (the lessee) at a flat monthly rate for a specified number of years. Lease terms can vary substantially, but they typically extend over the asset’s useful life. Payments include imputed interest costs, which are generally at higher rates than the interest rates banks offer for term loans.
Leasing may be advantageous for high-tech equipment that’s likely to become obsolete — or if you’re planning any major changes (such as a move or a merger) during the lease term. There are two types of assets under current U.S. Generally Accepted Accounting Principles (GAAP).
Capital leases. Some leases automatically transfer ownership to the lessee at the end of the term (or provide “bargain” purchase options), so they’re treated similar to term loans for tax and accounting purposes. Under current accounting practice, capital leases must be reported on the balance sheet, and only the amount of the lease payment that’s attributable to interest may be deducted for tax purposes. In addition, the lessee may deduct depreciation expense on capital leases for tax reporting.
Operating leases. These contracts are similar to rental agreements that give the lessee the option to purchase the asset at the end of the lease term. (The lessee can also return the equipment or extend the lease for an additional time period.) Under current rules, operating lease payments are fully deductible for tax and financial reporting purposes.
New Lease Rules
The rules for reporting leases under will soon be changing. In a nutshell, the updated lease standard eliminates the distinction between operating and capital leases for leases of 12 months or longer for financial reporting purposes. Starting in 2019 for public companies and 2020 for private ones, all leases must be reported on the balance sheet under GAAP.
It’s important to understand how the new lease standard will affect your company’s financial statements and financing decisions. Before upgrading your IT or production equipment, contact us to help evaluate your options.