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.

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 currently deduct.

Factors That May Lead to Recharacterization

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 examples:

• A portion of your rental payments establishes equity in the leased property.
• 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 property.
• Your rental payments substantially exceed the fair rental value of the property.
• 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 lease.
• 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.