Editor’s Note: This article was originally published in October 2014. Since then there have been some changes to rules for lease accounting and to tax laws.
With the approval of new rules for lease accounting by the Financial Accounting Standards Board in 2016, lessees are considering how the new standard will affect them. Many of the lease accounting changes are relatively neutral and should not impact the ability of companies to acquire productive equipment to operate and grow their businesses.
The primary reasons to lease equipment will remain intact under the new standard, which is known as Accounting Standards Codification Topic 842 (ASC 842) and will generally take effect in 2019. One of the key changes is that leases previously classified as operating leases under current accounting standards will now be capitalized and thus reported on corporate balance sheets. With the changes in balance sheet reporting, some financial statement ratios may be affected.
In January 2016, Congress approved legislation that permanently extended the Section 179 small business expensing limitation of $500,000. However, bonus depreciation is being phased out over a 5-year period for property acquired and put in service during 2015-19. The bonus depreciation percentage is 50% for 2015, 2016 and 2017. In 2018, it will be phased down to 40% and down to 30% in 2019.
For years, leasing equipment was about as popular among farmers as a prolonged drought.
But thanks to a variety of factors — including declining crop prices, higher input costs and changes in tax laws that made incentives to take out loans to buy equipment uncertain — that’s all changed. Equipment dealers now find that farmers are grudgingly changing their minds and embracing leases as they strive to improve cashflow and reduce debt on their balance sheets.
In other words, even as commodity prices soften, portending a difficult equipment sales environment, dealerships now have a new financial tool in their arsenal to help close equipment deals.
“In the last year or so, leasing has really taken off,” reports Kreg Parmer, a salesman at Pioneer Equipment Co. in Idaho Falls, Idaho. “I’d say that about 60% of my sales in the last year were purchased with leases.
“A decade ago, everyone was shying away from leases,” notes Parmer, who’s been a salesman at Pioneer since 2001 and sells an average of $9-$11 million worth of equipment a year. “Interest rates on leases ranged from 8% to 12% and the residuals (the amount owed at the end of a lease) were very high.
“We even had some old finance leases out there that were totally upside-down, and it was a battle to get those farmers out of their equipment because they owed more money at the end of the lease than the equipment was worth,” he adds. “That made it hard to get them traded out and into another purchase.”
Other factors contributed to skepticism about leases, including a bias toward ownership created by the incorrect perception that leasing implied a farmer was financially weak, says David Freeh, vice president, agriculture sales manager at TCF Equipment Finance.
“About 60% of my sales in the last year were purchased with leases…”
“When I got into leasing 28 years ago, my Dad was afraid to admit to neighbors that he leased,” Freeh recalls. “However, this stereotype certainly was not true. Some of the most successful farmers and agribusinesses that I have dealt with are seeking to maximize their profitability and view lease products as an attractive option for their businesses.
“The economic climate also has changed,” he adds. “For the last 12 years, the tax laws and generally high commodity prices have encouraged paying cash for equipment or taking out loans and quickly writing down the value.”
Farmers also may have been gun shy because of so-called fair market value (FMV) leases, which were common in the 1970s and ’80s, says Duane Maciejewski, vice president at AgDirect LLP. Though commonly used in other industries, FMV leases gave leasing for agricultural equipment a bad name because farmers often found that at the end of a lease, the fair market value of the equipment was much higher than they anticipated when they originated the lease.
Tax Law Changes Push Leasing to the Forefront
Tax laws used to make bank loans much more attractive to equipment buyers than leases. But that bit of conventional wisdom got flipped on its ear as of January 1, when Congressionally approved changes to Section 179 of the federal tax code went into effect.
Until then, Section 179 allowed businesses to write off up to $500,000 of a capital equipment purchase (price to not exceed $2 million) in the year in which it was purchased.
“So if a farmer bought a $200,000 piece of equipment, he could write it all off in that first year,” explains Jim Falk, the director of knowledge management at Agricredit Acceptance LLC. “That made a huge difference in their tax refunds or the amount of taxes they owed.”
In addition, a business could take what was called a “bonus depreciation” of 50% of the difference between the total purchase price and the $500,000 write-off. So a farmer who bought a $700,000 piece of equipment could write off $500,000 and then claim a depreciation of $100,000 (half of the difference between $700,000 and $500,000).
Or they could take the standard 10.7% deduction of the $700,000 that first year, Falk says. Little wonder that loans trumped leasing.
But now the Section 179 write-off, originally passed years ago to motivate businesses to make large capital purchases, stands at its lowest level since 2003, notes Falk, who leads seminars that educate dealership sales people about equipment leasing. Businesses can now write off up to $25,000 of a capital goods purchase that costs up to $200,000 and there’s no more bonus deprecation. “So companies buying big equipment may be better off depreciating it at the old schedule,” he says.
Of course, using the bonus depreciation had its drawbacks, too, since it didn’t leave farmers and other business owners much to deduct in ensuing years when they might need the tax break. But overall, farmers usually found the lure of a large, one-time tax break too good to resist, Falk says.
Like so many things, however, Section 179 is subject to the whims of Congress, which is under pressure from multiple groups — including agricultural equipment manufacturers and dealers — to restore Section 179 deductions to their previous level. In fact, the U.S. House of Representatives voted in June to reinstate the deductions, although the U.S. Senate deferred voting on the matter until after the November general elections, which adds more uncertainty for dealers.
“There are two schools of thought right now,” Falk explains. “Some people believe that adjustments to Section 179 will not happen this year. Others think politicians will use it as a campaign issue and promise to reinstate it if they’re elected.”
And just to make it more complicated, keep in mind that some past adjustments to Section 179 have been made retroactive to a prior year. “It could go retroactive to January 1, 2014,” Falk says.
Like the weather, the only certainty is uncertainty.
“So they were often surprised to find they had little to no equity at the end of the lease,” Maciejewski explains. “That left a bad taste in their mouths. Most lease structures today allow for the customer to know what the buyout will be at the end of the lease.”
It’s much easier now for dealerships to get customers to buy into the idea of leasing equipment. But to quell lingering suspicions, salespeople will have to thoroughly educate farmers about the ins and outs of leasing equipment, Parmer emphasizes.
“Most farmers don’t care for a lease until you sit down and explain it to them,” he says. “And I always tell them, ‘Don’t just take my word for it.’ They should ask their accountant, too.
“Most times they’re afraid you’re not telling the truth about things like excess-usage fees not coming into play if they trade in a machine,” he adds. “They have this misconception that it’s going to come back and bite them at the end of the lease.”
To better inform customers, it’s best to start at square one. First of all, dispel any notion that a lease is similar to a bank loan. It’s not, although both are considered financial tools that can help customers manage cash flow, maximize tax benefits and upgrade their equipment.
A lease is a fixed-term agreement that typically runs for 3, 5 or 7 years. This contractual relationship obligates the person leasing the equipment — the lessee — to pay the equipment owner (usually a leasing company) — known as the lessor — a fixed payment for the duration of the lease, Freeh explains.
“Essentially, the lessee uses the equipment in return for paying a rental stream, just like with a car lease,” Freeh says. To provide customers with maximum flexibility in terms of cashflow, payment options for ag equipment leases vary widely, from annual and semi-annual to quarterly and monthly.
At the end of the lease, the user can return the piece of equipment to the lessor. Or the lessee might opt to keep the machine by paying the lessor what’s known as a residual — a fair-market value that’s often capped at a predetermined value at the end of the lease. The lessee also can opt to trade in the machine for a newer machine, Freeh explains.
During the lease, the lessee assumes many obligations. Generally speaking, these include making payments on time, insuring the machine, paying any applicable sales taxes and ownership costs, fulfilling maintenance requirements and keeping the machine in good condition (nothing more than general wear and tear allowed). In addition, just as someone who leases a car must stay within predetermined mileage limits, the lessee of a piece of farming equipment must remain within a specified number of operating hours.
“You also can’t modify the equipment from its original specifications or use it for anything other than the job for which it’s intended,” Freeh adds. “Not following the requirements can affect the value of the equipment at the end of the lease. If you don’t follow the rules, you may be subject to a penalty or fee at the end, similar to not getting your deposit back because you damaged an apartment in college.”
But here’s a point worth stressing: If a lessee opts to trade in the machine, the excess use charges aren’t imposed.
What kind of equipment can be leased? Some finance companies will back leases for just about anything, including buildings, grain bins, processing lines and packaging equipment. At Pioneer Equipment, however, Parmer says tractors are the most common machines leased.
“We don’t lease nearly as many combines, hay swathers and tillers because they get so much more wear, so they don’t hold their value,” he explains. “Leases don’t work as well for equipment that gets dragged on the ground or for higher wear equipment because the residuals are too low at the end — maybe 15% on tillage equipment — so a farmer has little equity built up for a trade-in. At that point, you would have been better off purchasing the machine and be done with it.”
Types of Leases
In broad terms, there are two different kinds of leases for farm equipment: a true lease, also known as a tax lease, and a conditional-sale lease, also known as a bargain-purchase or finance lease. Each one is treated differently from a tax liability standpoint.
With a true lease, farmers can deduct lease payments as an operating expense on their income tax returns. But because the lessor still legally owns the equipment, not the farmer, the farmer cannot claim any depreciation on the asset.
“A true lease is designed specifically for tax purposes,” Maciejewski says. “It’s just like renting a piece of ground, you get to deduct the payments. If you pay $30,000 in lease payments in a year, you deduct $30,000 off Schedule F, just like other expenses such as fuel, seed and interest on loans.”
With a conditional-sale lease, the exact opposite is true. Farmers cannot claim lease payments as an operating expense, but can write off the depreciation of the machine, just like they can with a bank loan.
True leases are much more commonly issued than conditional-sale leases because the tax deduction from the lease payments typically can be more beneficial than the depreciation write-off. It’s also more advantageous from a tax planning standpoint because the payments write-off is an even, predictable fixed amount for the duration of the lease.
So what if a customer asks which kind of lease is better? The answer ultimately depends on the customer’s cash flow and tax circumstances, and whether or not they want to own the equipment at the end of the lease. Crop prices also can influence the decision. If corn prices are high, for instance, a farmer may want more depreciation to mitigate tax exposure. The bottom line: Consult with a qualified accountant, experts say.
“A true lease provides the benefit of a level deduction of payments over the life of the lease and someone else takes the ownership risk … you can walk away from it if you want,” Maciejewski notes. “If the residual is $20,000 and the piece of equipment is worth $15,000, you can turn it in. But if it’s worth $30,000, you may want to buy it for $20,000 and have $10,000 more in equity.”
Leases vs. Loans
So what’s the best way to get customers who are used to taking out loans to buy equipment to consider leasing instead? Like so many other things, ask them to follow the money. Under current tax laws (see sidebar for details), leases now offer much greater deductibility than loans. In addition, lease payments typically are lower than loan payments.
“To move equipment in tight (financial) times, leasing is definitely a good option,” Parmer says. “For example, in our region, we were heading for an absolutely great grain crop, but then the weather ruined about 50% or 60% of the malt barley. Instead, it’s now being sold as feed barley for about half the expected price, and a glut of feed barley is pushing the price down even more. So in this instance, lower payments through leasing are a more attractive option.”
Moreover, a bank will usually require a 20-25% down payment on a loan for a new machine.
“Under a lease, all you’ll typically need to bring to the table is 2-3% of the asset cost…”
Duane Maciejewski, AgDirect
But with a lease, only the first payment is due up front. “So if you’re a dairy farmer who’s on a monthly milk check and is trying to preserve cash, but you need a new skid steer that costs $30,000, you have to come up with $6,000 if you take out a loan,” Maciejewski says. “Under a lease, all you’ll typically need to bring to the table is 2-3% of the asset cost, depending on the residual amount.”
Lower payments and up-front costs, in turn, provide farmers with the financial flexibility to take advantage of new business opportunities that may arise during the life of the lease, as well as accommodate financial emergencies, says Jim Falk, the director of knowledge management at Agricredit Acceptance LLC. Another point to consider: Because lessees don’t legally own equipment, it doesn’t appear on their balance sheets, which gives them more capital to work with, Parmer says.
Freeh says he generally recommends 5-7 year leases because they give farmers more flexibility as well as lower payments. The latter is especially helpful if commodity prices fall. Furthermore, if there’s a glut of used equipment coming off leases at the same time, a longer lease will enable the dealer and the farmer to work together to manage the asset and allow more for that excess inventory to sell off, he notes.
“The lessee also may look at trading the equipment during the lease term,” he points out. “It depends on the leasing company, but some will allow you to buy out the lease early and acquire a new asset.”
In the end, Falk points out that many farmers don’t buy equipment when leases expire anyway. Instead, they prefer to trade in for newer equipment that’s less prone to breakdowns and offers more productivity through technological advances. “So you’re effectively only paying for the use of the equipment during the lease,” he says.
“Some of the most successful farmers I have dealt with view leases as an attractive option …”
To best serve customers, salespeople should advise them to do their homework about residual values before signing on the dotted line. Industry observers suggest using resources such as Iron Solutions (www.ironsolutions.com) to determine if residuals are in the ballpark. In other words, if something seems too good to be true, it usually is.
Parmer also points out that unlike loans, lease terms are negotiable for items such as the interest rate, the residual and the down payment.
“We can offer a lower residual and higher payments for tax purposes, or a higher residual and lower payments,” Falk adds. “Farmers just have to know what to ask for. Take a look at the asset. Will it maintain its value in a down market? Will the payments allow me to maintain a profit margin even with highs and lows in commodity prices? Talk to a qualified accountant and break down the cost per acre or per hour. Farmers have become much more sophisticated and can break down in detail the cost of operating the equipment.”
“It can’t hurt to ask what terms are negotiable,” Parmer notes. “As a sales person, you have to work your angles. Sometimes a farmer will say a certain lease just won’t work, so you have to get creative. I’ll talk to them about raising the residual or lowering the interest rate or work on the down payment — figure out how I can make it work for them.”
Keep in mind that the items being negotiated usually have an associated cost. For example, to gain more operating hours on a machine will make the lease more expensive. And the more hours a farmer puts on a machine, the faster it depreciates in value, Falk points out. “And if you want to get out of the lease early, some lenders charge a pre-payment fee,” he adds.
But overall, Parmer sees few disadvantages to leases for both dealerships and farmers. In most cases, the dealership is responsible for the piece of equipment after the lease, so it’s in their best interest to make sure the residual value is set at a level conducive to resale. And over the last few years, residual values have come in line better with actual values at the end of the lease, he says.
In the end, Parmer says it’s gratifying when customers who initially were skeptical about leases report positive results. “They tell me that they really benefit from the lower payments and better cash flow, and have options if things go bad.”