What are business assets, and how do you decide whether to lease or buy them?
In the context of the lease versus buy decision, "business assets" refers to fixed assets (such as buildings, machinery, and office equipment) that can usually be depreciated over time. Because these fixed assets are necessary to the operation of most businesses, a question often arises as to whether the business owner should purchase the assets outright or lease them from another party. There are advantages and disadvantages to both leasing and buying. Therefore, your decision should be an informed one, based on the needs of your business and your own preferences.
What is depreciation, and how can it influence your decision to lease or buy business assets?
The IRS assumes that certain tangible business property will decline in value over time due to wear and tear, exhaustion, or obsolescence. Consequently, each year, a portion of the property's value is subtracted (i.e., taken as an expense), based on how long it is expected to last. This is known as depreciation. The Internal Revenue Code specifies the types of business property that can be depreciated, as well as the amount of depreciation allowed each year and the overall depreciation time frame. Although the buildings, machinery, and office equipment you own can be depreciated, in most cases your land and personal assets cannot be depreciated.
Because depreciation expense helps to minimize your taxes, the ability to depreciate might be a major factor in your decision to lease or buy business assets. In general, you can depreciate only the business assets that you own; you cannot take a depreciation deduction for most business assets that you lease from another party. However, it is possible in some cases for you to deduct your lease payments as an operating expense.
Tip: Instead of depreciating the cost of business assets over time, small businesses can write off a portion of the cost of new assets in the year they are purchased and put into use. This provides an immediate tax benefit. In 2022, the maximum amount that can be deducted is $1,080,000, with a phase-out that starts when purchases for the year exceed $2,700,000. Amounts are indexed for inflation each year.
What are the advantages and disadvantages of leasing business assets?
A lease is a written contract to rent realty or personalty (tangible property). One party owns the property, while the other party uses the property and pays for its use. There are both advantages and disadvantages to leasing.
- Improve your cash flow
- Hedge against obsolescence
- Provide fixed monthly payments that you can plan for
- Allow for a smaller initial cash outlay
- Generally provide easier credit terms than a bank loan
- Possibly provide an operating expense deduction
Leasing has become increasingly popular in recent years. The main advantage of leasing is the reduced initial cash outlay. You can obtain the use of a business asset with a lower initial cash expenditure than you would if you had purchased the asset outright. In the manufacturing industry, in particular, this can be a big advantage because of the high cost of machinery. Cash flow may be improved because you pay for the machinery or equipment as you use it to generate income for your business. Leasing also acts as a hedge against obsolescence; it may help you to keep up with improving technology. For computers, communication devices, and other equipment that is subject to rapid technological improvement, you'll be able to update more quickly if you've signed a short-term lease or one that provides for upgrades.
Of course, there are certain disadvantages to leasing as well. For one thing, leased assets cannot provide you with depreciation expense. In addition, leases can be risky. If you run into cash flow problems or if your business goes under, you may still be legally responsible for continuing the lease payments. Finally, of course, leases are more expensive in the long run because of the interest charged.
What are the advantages and disadvantages of buying business assets?
There are a number of advantages and disadvantages to buying business assets.
Purchasing business assets instead of leasing them from another party provides your business with a depreciation expense opportunity, which can be a significant tax advantage. Moreover, although leases typically charge fixed interest rates, these rates are often significantly higher than the variable rates charged by banks for bank loans. Bear in mind, though, that most banks don't offer 100% financing for the purchase of business assets. Still, you'll end up paying less money in the long run when you buy instead of lease. Finally, purchasing assets is certainly less risky if you buy them outright instead of relying on a bank loan or a lease. If the business goes under, you won't have to worry about continued payments.
The advantages of leasing constitute the disadvantages of buying. In particular, think about:
- The larger initial cash outlay needed when you buy an asset
- Cash flow difficulties
- Technological obsolescence of your purchased asset
Your decision to lease or buy should be a careful one, made only after thoughtful consideration of the respective advantages and disadvantages of both leasing and buying.
This article was prepared by Broadridge.
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