Understanding Recharacterization When Leasing Heavy Equipment

25 June 2015
 Categories: , Articles

When it comes to heavy equipment, there is often a fine line between the cost of heavy equipment leasing and a purchase agreement. Although you may be tempted to simply purchase your equipment outright, this is not always the best choice. There are many advantages to leasing, and one of the main advantages is the tax deductions you can claim for the cost of your lease payments.

Unfortunately, if your lease contract is not written correctly, the IRS may recharacterize your deductions, which in turn may cause the IRS to deny them. This will not only change the amount of your deductions, but may also cost you penalties and fees. To make sure your lease agreement is in compliance with the IRS, there are several factors you want to avoid.

What Is Recharacterization?

According to the IRS, recharacterization, or recharacterisation, is the changing or treatment of a particular class of monies differently than what may have been initially indicated. These rules commonly apply to IRA contributions, but can be applied to any tax scenario.

What Is The Difference Between Depreciation And A Lease Deduction?

If you lease your heavy equipment as a part of your business, you are generally entitled to deduct the cost of your lease payments on your taxes for the entire period of your lease. Once you end one lease and go into another, you are able to continue to deduct these payments for the years in which they are made.

If you purchase your equipment outright, you can only deduct the cost of the depreciation the equipment has incurred, and then only if it has met certain rules. The number of years you are able to take this depreciation is directly linked with the class life of the equipment. You may also be able to deduct the interest portion of your installment agreement.

Lease payments are often higher than the amount you will be able to take using depreciation. This means if the IRS chooses to recharacterize, or disallow, this deduction, you will probably owe a higher tax bill. If this is not caught initially, and has been going on for a number of years, you could find yourself owing substantial penalties and fees.

One of the reasons the IRS will disallow the deduction is if they view your leasing agreement as an actual installment agreement. This is often because of the language your leasing agreement contains.

What Are The Factors You Want To Avoid?

Certain things within your lease agreement will send up red flags to the IRS. Some of these factors are

  • Your lease payments are much higher than the usual rental value of the property you are leasing
  • You are building equity in the equipment you are leasing
  • A title will be conveyed at the end of your lease, or after you have paid a specific amount
  • You are able to purchase the equipment for a nominal fee, which is far below the value of the equipment, at the end of your lease
  • Your rental contract includes interest fees, or fees which would be the equivalent of interest

These are just a few examples, there are more. If you enter into a rental agreement that contains any of these things, know that this agreement could cause your taxes and deductions to come under closer scrutiny from the IRS, and if you are like most business owners, that is the last thing you want. 

Every tax situation is different. Before you make a decision to lease, or purchase, your equipment based on tax consequences, consult the services of a tax accountant. They will be able to examine your specific situation and give you the best tax advice.