A Trade of Equipment on an Operating Lease can be Costly
With tougher times in the farm industry, equipment companies and banks have been promoting operating leases to farmers. In many cases, the farmer will “trade-in” equipment in return for not having to pay any of the operating lease payments or making a large down payment on the lease. If the trade of equipment was for a capital lease (the IRS essentially treats this as a loan), the farmer would owe no gain on the trade (assuming he got no cash).
However, when the trade is for an operating lease, the farmer will have gain equal to the amount of “trade-in” value credited to the operating lease less his tax cost in the equipment. He will only be able to offset the gain with lease expense equal to the amount of lease cost amortized for the year of sale. Let’s look at an example:
Farmer Case trades in a 2011 John Deere tractor worth $120,000 for a new John Deere tractor under an operating lease over four years. The trade-in occurs on December 31, 2016. Farmer Case has fully depreciated the tractor. He will have ordinary income of $120,000 in 2016 and will have no lease expense deduction (the trade occurred on the last day of the year). Rather, he will expense $30,000 during 2017-2020.
We have witnessed several cases where the tax hit in year one has been over $100,000. Economically, the farmer will break even over the term of the lease, but in today’ environment, coming up with extra taxes in year one can be painful.
Sometimes the farmer can convert this lease to a capital lease (many of the leases are capital leases even though the bank or equipment dealer will call them operating). If they can, there will be no tax hit in year one, but also no deduction for the lease payments (there will be some interest to deduct).
If you are looking at doing one of these leases, make sure to discuss it with your tax advisor first.
Paul Neiffer, CPA