Lease vs. Buy?Posted in: Business June 22 2016
Determining the Best Options for Your Farm
This is an area in which many farmers struggle to make a decision. In reality, there is no right or wrong answer to this question. Either way, it’s ultimately a decision that everyone needs to make, so here are some things to consider that may help you decide what’s best for your farm.
When you lease an asset, 100 percent of the payments are considered tax deductible when they are paid (some exceptions apply in the case of a large down payment). This gives you good matching of the cash outflow to the tax deduction.
When you purchase an asset, it is added to the appropriate pool of undepreciated capital cost (UCC) and depreciated at the respective rate for that class, with only half of the depreciation allowed in year one. In this case, since a purchase normally requires a 25-percent down payment, and since principal payments are not deductible, there is often a mismatch of the cash outflow to the tax deduction.
For the major capital purchases like a combine, tractor or sprayer (class 10 assets – 30 percent declining balance depreciation rate allowed); over a five-to-seven year period, the tax works out roughly the same. However, the timing of the deductions are not the same. For the assets mentioned, which are class 10, you get a tax advantage in the early years if you buy it. This is because the tax deduction will normally exceed the lease payment amounts for those first three years. After about three years, the scale tips the other way, and the tax deduction becomes less than the lease payment.
If you are looking for a quick tax deduction, you typically get more in the short run via a purchase.
If you find a deal where the down payment is low, or nothing at all, you will be ahead if you buy the asset. However, if you were required to make a 25 percent down payment, the tax deduction may never exceed the cash outflow. Therefore, if your goal is to match cash outflow with tax deductions, a lease may be a better option.
For slower depreciating items like grain bins for example (class 6 – a 10 percent declining balance depreciation rate allowed); a short term lease (i.e. three years) is very attractive for tax purposes. It would take several years for the tax deductions to catch up to the lease under a buying scenario. Leases are quite popular when acquiring bins, however, there is usually a cost to the lease that overall, if one was to ignore the tax effects, would make most people decide to buy the bin.
Note: Be careful if you have always purchased your assets in the past, and now you are switching to a lease. Your trade has to be disposed of for tax purposes, but your new asset is not added to your UCC pool, so you could end up with a negative tax consequence in year one.
Often with leases, you are not required to make a down payment (normally 25 percent on a buy), and the lease is set up such that the payments you are making only end up paying the principal down to 50 percent of the value in years one to five, and then if the farmer likes the machine and wants to buy the lease out, they can do so and finance the machine over another five to seven years, giving them 10-12 years of financing. Although there is a cost for this, it does spread out the cash needs. If you are a farmer who prefers to keep your machinery longer periods of time, this can work quite well but you will pay a lot of interest.
Service Life Considerations
If you are a farmer who wants to run new equipment all the time, we are finding that owning it can cost you more cash when you factor in amortization and interest, as some of these new machines do not hold their value that well. So, leasing may have its advantages, if you can predict the value drop in that machine.
If you are a farmer who likes to keep machinery forever, owning is almost always going to be cheaper, as the interest rates associated with leasing are usually higher. Just pay careful attention and watch out for those “lease administration and other hidden fees”. When factoring those in, the interest rate can go from the advertised 5 percent to something much higher, in some cases closer to 12 percent.
Remember, leasing companies are in the business to make money as are those who finance purchases. Overall, our experience is that leases generally cost more (when you ignore the tax), but that differential has been shrinking. Some financial institutions are now offering some very attractive leases. A good business advisor can help you determine which deal is the best for you, so you keep as much of your hard earned money in your pocket.
For more information, contact Stuart Person, Agriculture Business Advisor with MNP, at email@example.com.
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