Texas Sales Tax on Equipment Leases
If you lease equipment for the purpose of renting it to someone else, you may need to charge a sales and use tax in Texas. However, if you are renting the equipment to someone but you will operate the equipment, you do not need to pay sales and use tax on the rental. Only the service is charged tax.
However, if you rent out the leased equipment without operating it yourself, a sales and use tax applies.
Automobiles
Texas is the only state that still taxes the capitalized cost of a leased vehicle. In other states, generally only the monthly lease payments are taxed, similar to the new law in Illinois.
Types of Lease
Two general types of lease plans are available. The major factor that distinguishes these plans is how they are treated for tax purposes.
Operating Lease
An operating (or true) lease calls for a series of regular payments, usually annual or semi-annual, for a period of years. At the end of the lease period, you have the option of purchasing the machine at a price approximately equal to its fair market value. The option price may be set when the lease is signed or it may depend on the accumulated use and condition of the machine when the lease expires.
Alternatively:
- The machine can be returned to the dealer or lease company
- Or the lease can be extended.
Tax treatment:
- Lease payments are reported as ordinary expenses on your tax return.
- If the purchase option is exercised, the machine is placed on your depreciation schedule with a beginning basis equal to the used purchase price.
Finance Lease
A finance lease is treated as a conditional sales contract by the IRS. You are considered the owner of the machine so it is placed on your depreciation schedule.
Tax treatment:
- Payments made to the lease company must be divided into interest and principal, with the interest being tax-deductible.
- Many finance leases are essentially installment loans with balloon payments after three to five years.
At the end of the lease period, you have the choice to either:
- Return the machine to the dealer (and give up ownership)
- Make the balloon payment (and take ownership)
Since the finance lease is not taxed as a true lease, the final buy-out price (balloon payment) can be quite variable depending on:
- The length of the lease
- The size of the payments
Advantages of Leasing
Although leasing may not be for everyone, there are several advantages:
- Lower payments compared to most conventional loans. (One reason the payments are lower is that you are building little or no equity in the machine. At the end of the lease period you have nothing except the right to exercise the purchase option.)
- Utilizes operating capital instead of investment capital. Payment schedules can be matched to periods of high cash flow. Cash requirements for machinery are constant and known in advance. This is particularly beneficial for high volume, low equity operators who can’t afford large capital outlays at a point in time.
- If you routinely trade major machinery items every few years, leasing generally offers lower payments than loans used to purchase the machine.
- If you are near retirement, you may prefer to lease equipment so it can be easily liquidated in a few years with no income tax recapture.
- Leasing allows you the chance to try out a particular machine for a few years without buying it.
Not for Everyone
Lease companies are in business to earn a return on their capital. If you have enough money to purchase machinery outright, you will usually spend less in the long run by owning it. This is especially true for machinery that will be owned for five to ten years or more. In addition, you build equity through ownership.
Expense Method Depreciation
In addition to regular depreciation, you may be eligible for expense method depreciation during the first year. This deduction is available for machinery purchased or leased under a finance lease, but not under an operating lease.
You may prefer to acquire the machinery by:
- Outright purchase
- Financial lease
to take full advantage of the early depreciation option.
However, if you buy other property that can also utilize the expense method depreciation, you may have already reached your limit for the year.
Include on the Balance Sheet
Sometimes leasing is touted as “off balance sheet financing”. However, while an operating lease is not a loan, it does represent an obligation to pay and a cash flow commitment is incurred.
The Farm Financial Standards Council does not recommend that leases of capital assets be shown as a liability on your balance sheet. Likewise, the leased equipment should not be shown as an asset.
Frequently Asked Questions
Do I need to charge sales tax if I lease equipment to others?
Yes, if you lease equipment and do not operate it yourself, you must charge Texas sales and use tax on the rental. However, if you provide an operator with the equipment, only the service is taxable, not the rental itself.
How is leasing a vehicle taxed in Texas?
Texas uniquely taxes the full capitalized cost of a leased vehicle upfront, unlike other states that tax only the monthly lease payments. This can significantly increase the initial tax burden on lessees in Texas.
What is the tax difference between an operating lease and a finance lease?
An operating lease treats payments as regular business expenses and offers flexibility at the end of the term. In contrast, a finance lease is considered a purchase for tax purposes, allowing depreciation and requiring interest and principal separation in payments.
Can I use expense method depreciation on leased equipment?
You can use expense method depreciation on equipment leased under a finance lease, but not under an operating lease. This deduction can significantly reduce taxable income in the first year, provided you haven’t hit your annual limit.
Is leasing a good idea if I plan to keep the equipment long-term?
Not usually. If you intend to keep the equipment for five to ten years or more, buying it outright generally costs less over time and allows you to build equity, something leasing does not provide.