To illustrate the tax benefits of leasing, we will explain the different taxable situations you will be involved in depending upon whether you choose to pay cash, utilize a bank loan or lease your equipment.
The first method of obtaining equipment is to pay cash. This method is very expensive because it uses after-tax dollars. In other words, if you are in a 34% tax bracket, you must earn $15,152 to be left with $10,000 for buying new equipment. You must then depreciate the investment over its useful life. Therefore, the economic cost is $15,152 plus the loss of interest if the money remained in the bank.
The second method is bank borrowing. Here you are allowed to deduct the interest as an operating expense, and the only way you can recoup your investment is through long-term depreciation. You must depreciate the equipment over its useful life. This means you will still be taking depreciation on the equipment years after the bank note is paid off.
The third method is equipment leasing. Each lease payment comes from pre-tax money and each payment is fully deductible as a direct operating expense (FMV or 10% Option). You are not depreciating your equipment over its useful life. Instead, you are writing off the entire cost of the equipment during the term of your lease agreement, normally three to five years. Therefore, you have sheltered considerably more income during the term of the lease agreement, than you would have through bank borrowing or outright purchase. Since you have sheltered more income, you have earned more money. Once the lease is over, you transfer the asset to your balance sheet. Depreciation can be deducted off of the remaining value of the equipment.
Note: A lease can typically be written off as a rental expense if there is no intention to purchase. That is, the equipment is simply being rented. You should always consult with an Accountant before making a decision.
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