What are the Tax Benefits of Equipment Financing?
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Taxes, Taxes, Taxes...
Taxes are a fickle entity in the ever-expansive world of business finance. Heck, entire careers are built around consulting businesses on how to maximize their taxes every year. But, with careful planning and a little bit of homework, you can make a sizeable impact on the tax benefits gained from equipment financing or leasing simply by understanding Section 179 and bonus depreciation.
Disclaimer: the information in this post is only intended to inform, not to serve as individual tax advice. I am not a tax professional and you should always consult one if you have any questions about your taxes.
Perhaps the most foundational tax law you should understand before attempting to maximize your benefits is Section 179. Section 179 is a tax incentive designed for small businesses that lease or finance their equipment. It allows you to deduct the full purchase price of your equipment or software (provided it qualifies) from your gross income instead of the traditional method of only deducting the calculated depreciation on the equipment each year.
It’s important to note that you must be the registered owner of the equipment in order to deduct it with Section 179. That means operational leases and rented equipment DO NOT qualify.
Section 179, as great as it is, is not without its restrictions. Luckily, those restrictions are split into three easy to understand categories:
- Income caps
- Equipment eligibility
1. In the spirit of keeping Section 179 as a tax incentive for small businesses, spending caps are implemented each year to keep larger businesses from taking advantage of the deductions. It works by setting two limits: one for the amount you can deduct that year ($1,050,000 for 2021) and one for the total amount of qualifying equipment purchased ($2,620,000 in 2021). Once you surpass the second limit, your deductions are reduced dollar-for-dollar. For example, if you purchase $2,720,000 worth of qualifying equipment in 2021, you’ll only be able to deduct $950,000 (and so to not invoke the ire of my high school calculus teacher, I’ll show my work: $2,720,000 – $2,620,000 = $100,000 and $1,050,000 – $100,000 = $950,000).
3. Not all equipment or software are eligible for Section 179 either. While there are exhaustive lists of what qualifies, you can generally assume that machinery equipment, office furniture and equipment, and “off-the-shelf” software are eligible. Understanding what is eligible can save you from exceeding the spending cap or incorrectly deducting something that doesn’t qualify.
Bonus depreciation is another great tax incentive for businesses that finance their equipment. Normally, a business is required to depreciate their property over the span of its “useful life” or expected time in use.
For example, if business A finances a piece of equipment that costs $15,000 with a useful life of five years and doesn’t opt for any form of bonus depreciation, the equipment will automatically be depreciated and deducted from their taxable income at a rate of $3,000 a year.
With bonus depreciation, however, they can accelerate this deduction by a certain percentage depending on the year the equipment is put into service. In 2021, you can deduct 100% of the equipment cost.
Unlike Section 179, however, bonus depreciation is not limited by your business’ income, can’t be applied individually, and can’t be carried over. If you decide to use bonus depreciation, it will apply to all eligible equipment purchased that year at the set deduction rate for that year. If the full deduction exceeds your gross income, then the remaining deduction will be applied to your taxes from previous years.
To refer to our previous example:
If business A claims 100% bonus depreciation on equipment worth $15,000 in year B while reporting a gross income of $5,000 that year, it will create a net operating loss (NOL) which can come with its own tax benefits that can be carried into future years.
Important Information Regarding Leases
The tax deductions available for your leased equipment hinges on whether it’s a capital or operating lease. If it’s a capital lease (meaning the lessee is the registered owner of the equipment) the full price of the equipment can be deducted via Section 179 and/or bonus depreciation so long as it’s eligible.
Under an operating lease, on the other hand, the lessee can’t deduct the equipment cost via Section 179 or bonus depreciation as they’re not the registered owner of the equipment. Instead, the lessee can deduct the payments made on the lease as an operating expense. Depending on the asset leased, this could be more advantageous than using Section 179 or bonus depreciation.
Putting it all together
Ultimately, how you use the deductions available to you depends on your business goals. Both Section 179 and bonus depreciation have their unique benefits and can be used in tandem to help you get the most out of either method of deduction.
Some businesses use Section 179 to fine tune their deductions when bonus depreciation isn’t advantageous while others may deduct up to the Section 179 limit and use bonus depreciation for the rest.
Regardless of how you may want to use these deductions, it’s important to consult a tax or legal advisor as each business’ needs are different and what may seem advantageous in the short run may negatively impact future tax deductions.