Lease or Purchase?
Sometimes it's difficult to tell whether a taxpayer's payments are rent for the use of property or payments of the purchase price of that property, particularly where the lease gives the taxpayer an option to buy the leased property, especially for a minor amount at the conclusion of the purported lease.
Under Code Sec. 162(a)(3), rent payments are deductible, but payments of a purchase price must be capitalized under Code Sec. 7701(h). Each arrangement results in a far different tax treatment. Lease payments are deducted as rent, and in the case of a purchase, the item must be depreciated and may qualify for bonus depreciation or Sec 179.
A payment for the use or possession of business property is deductible as rent only if it's made for property to which the taxpayer doesn't take title or in which he has no equity. Thus, amounts paid ostensibly as rent which are part of the purchase price of the property aren't deductible as rent (Rev Rul 72-408).
Where a transaction that is structured as a lease is held to be a sale, part of each payment represents interest on the unpaid balance of the purchase price.
“ Example: An individual leases a machine to be used in his business. The market price per the equipment dealer is $70,000 and the total amount of the lease payments are $90,000 with an option to buy the machine at the conclusion of the lease for $1. Based upon the $1 option to purchase the equipment, this lease is a purchase, not a lease. Further factors used in making a determination are described below. ”
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The IRS has considered several tests, including whether the benefits and burdens of ownership pass to the purported purchaser. Rev Rul 55-540 contains a presumption that a transaction is a sale and not a lease where the total rental payments and any option price payable approximate the price at which the equipment could have been purchased at the time of entering into the agreement. The IRS also considers the following factors included in Rev Rul 55-540 in determining whether a transaction is a purchase/sale or a rental agreement:
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Portions of periodic payments are made specifically applicable to an equity interest to be acquired by the lessee.
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The lessee will acquire title on payment of a stated number of “rentals” required under the contract.
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The total amount that the lessee is required to pay for a relatively short period of use is an inordinately large proportion of the total amount required to purchase title to the property.
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The agreed “rental” payments materially exceed the current fair rental value (which may indicate that the payments include something other than compensation for use of the property)
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The property can be acquired at a price that is nominal in relation to the property's value at the time the purchase option can be exercised, at the time of entering into the original agreement; or the purchase price is a relatively small amount compared to the total payments that are required to be made.
IRS noted that the last of the above factors was of particular importance. in that factor, the lessee could have purchased the property for the amount of the rental payments. The taxpayer contended that it had paid an amount for use of the equipment that far exceeded the value of the equipment as appraised by IRS.
In determining whether the purported lease of a truck was instead a secured sale, the Tax Court held that the nominal lessor's benefits, obligations, and rights resemble those of a secured seller where:
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The lease term extends throughout the equipment's entire useful life,
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The lease is an open-end lease (i.e., the lessee assumes the risk fluctuation in the residual value of the leased property when the lease ends),
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Title automatically passes to the lessee upon conclusion of the lease or when the sum of the rental payments equals the cost of the equipment,
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The lessee has an option to purchase the equipment at a nominal or below-market price, or (5), the lessor has an option to compel the lessee to purchase the equipment.
Where none of these elements was present, the court held that the transaction was a lease, rather than a sale (Boyce, Arthur E. et ux., (2010) TC Summary Opinion 2010-100)
The fact that an agreement makes no provision for the transfer of title, or specifically precludes it, doesn't prevent the arrangement from being a sale (Rev Rul 55-540). On the other hand, the fact that the lessee ultimately buys the property he had been renting doesn't necessarily mean that a sale was intended from the start (Western Contracting Corp v. Com., (1959, CA8)).