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The Farm CPA: Learn Tax Implications of Trade-Ins

07:09AM Oct 01, 2014

With the possible elimination of bonus depreciation for 2014 and extremely low Section 179 deduction amounts (technically $25,000, though farmers who spend more than $225,000 get zero deduction), we are starting to see more promotions of equipment leasing by dealers. These promotions tout the immediate deduction of lease payments or a faster write-off of deductions than a farmer would get simply by purchasing the equipment and depreciating it over seven or eight years.

Many farmers also trade in equipment as a down payment on lease obligations. In several situations, trade-in value is equal to the total lease amount. My concern is farmers might not understand the resulting income tax implications.

First, consider some background on how leases are treated for income tax purposes. Operating leases allow for an immediate deduction of the lease payment by the farmer. Yet a lease will not be treated as an operating lease if:

  • Any part of the lease payment is applied to an equity position in the leased asset. A portion of the lease payments is designated as interest or the equivalent of interest. 
  • The lessee acquires ownership, or title, of the equipment upon a specified number of rental payments. 
  • Over the short time the equipment is used, the total amount a lessee pays is an exceedingly large portion of the total sum required to buy the equipment outright.
  • Equipment payments exceed the current fair rental value.
  • At the time any purchase option may be exercised, the title to the equipment can be acquired for an exceedingly small purchase option price in relation to the actual value of the equipment. 

If any of these bullet points is true for your lease, it will be treated as a capital lease, which is essentially the same as purchasing the farm equipment using a loan.

Unanticipated Consequences. Now let’s review the unanticipated tax consequences of these transactions. If a farmer trades in equipment on an operating lease, the trade-in value of the equipment that is applied toward the lease has two components. First, the farmer has sold the equipment for the trade-in value. Most farmers have fully depreciated this equipment, thus the farmer has a full taxable gain. Second, farmers assume they will be able to fully deduct the trade-in value as a lease deduction. Yet tax laws require farmers to amortize the lease payment over the life of the lease.  Farmers must recognize a gain, but they can only deduct the gain over the life of the lease.  

Suppose Farmer Johnson has $1 million of used farm equipment to trade in on a four-year operating lease of newer equipment. The new iron calls for four annual payments of $250,000. At the end of Year Four, he can purchase the equipment for fair market value. The farmer assumes no income or deduction will result, yet he experiences a gain of $1 million at the beginning of the lease, a $250,000 deduction in Year One and a $250,000 deduction from Year Two to Year Four.

If the lease contains one of the items that causes it not to be a tax operating lease, the trade-in becomes a Section 1031 exchange. This normally results in no gain or loss on the trade-in value, and if there is additional consideration owed by the farmer, the extra amount is depreciated.

Leasing farm equipment still has many merits, especially if the finance component of the lease terms calls for an interest rate lower than financing. Be aware, though, that income tax consequences might not always be what you desired.  Always review these transactions with a qualified tax adviser before pulling the lease trigger.