Equipment Leasing

<div class="Section1"><br /> <br /> <em>Editor&rsquo;s Note:</em> The 2017 tax reform legislation generally allows a 100 percent bonus depreciation for business owners with respect to property that is placed in service after September 27, 2017 and before January 1, 2023. Further, under the 2017 tax reform legislation, the requirement that the property be originally placed into service by the taxpayer is removed (i.e., tax reform permits accelerated expensing of used assets, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> In TRA 2010, Congress provided for 100 percent bonus depreciation (i.e., expensing the full cost) for qualified property placed in service after September 8, 2010, and before 2012.<a href="#_ftn2" name="_ftnref2">²</a> (ARTA 2012 extended the placed-in-service date through 2013 for a subset of qualified property that will continue to be eligible for 100 percent bonus depreciation: certain property with a longer recovery period, transportation property, and certain aircraft.)<a href="#_ftn3" name="_ftnref3">³</a> For other qualifying property placed in service after 2007 and before September 27, 2017, the bonus allowance is 50 percent (i.e., one half of the cost of the property can be deducted in the year the property is placed in service), and the rest of the cost is recovered using the otherwise applicable cost recovery method.<a href="#_ftn4" name="_ftnref4">⁴</a> In the latter case, the actual deduction in the first year will thus exceed 50 percent of the property&rsquo;s cost: the allowance will include not only the bonus depreciation but also the appropriate percentage of the rest of the cost of the property.<br /> <br /> The 2017 tax reform legislation once again changed the bonus depreciation rules. The bonus depreciation provisions will be phased out based upon the date the property was placed in service, as follows:<br /> <ul><br /> <li>Property placed in service after September 27, 2017 and before January 1, 2023: 100 percent expensing.</li><br /> <li>Property placed in service after December 31, 2022 and before January 1, 2024: 80 percent expensing.</li><br /> <li>Property placed in service after December 31, 2023 and before January 1, 2025: 60 percent expensing.</li><br /> <li>Property placed in service after December 31, 2024 and before January 1, 2026: 40 percent expensing.</li><br /> <li>Property placed in service after December 31, 2025 and before January 1, 2027: 20 percent expensing.</li><br /> <li>2027 and thereafter: 0 percent expensing.<a href="#_ftn5" name="_ftnref5">⁵</a></li><br /> </ul><br /> In the case of qualified property acquired by the taxpayer <em>before</em> September 28, 2017, and placed in service by the taxpayer <em>after</em> September 27, 2017, different rules apply. If the property was placed in service before January 1, 2018, 50 percent expensing applies. If the property was placed in service in 2018, 40 percent expensing applies. If the property was placed in service in 2019, 30 percent expensing applies, and if the property was placed in service after 2019, 0 percent expensing is permitted.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> For qualified property first placed into service by the taxpayer during the first taxable year ending after September 27, 2017, the taxpayer can elect to have 50 percent apply instead of the relevant percentage applicable to the year in question.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <p style="text-align: center;"><strong>Election to Expense</strong></p><br /> Bonus depreciation provisions have typically been enacted only during economically difficult times, and for short periods. In one form or another, however, IRC Section 179 has been around for a long time. Under that provision, a limited amount of the cost to acquire equipment can be expensed in the year when the equipment is first placed in service.<a href="#_ftn8" name="_ftnref8">⁸</a> In the case of partnerships and S corporations, the election to expense a portion of capital costs is made at the partnership or S corporation level.<a href="#_ftn9" name="_ftnref9">⁹</a> The deduction can apply to several pieces of property used in the active conduct of the trade or business.<br /> <br /> Recent legislation has raised the dollar amount that can be expensed for property placed in service in 2008 and beyond (these provisions were made permanent by the Protecting Americans from Tax Hikes Act of 2015 (PATH)). The aggregate cost deductible for 2008 and 2009 could not exceed $250,000.<a href="#_ftn10" name="_ftnref10">¹⁰</a><br /> <br /> The aggregate cost deductible for 2010 and thereafter was $500,000 (to be indexed for inflation; the amount for 2017 was $510,000). The annual dollar limitation was reduced by one dollar for each dollar of such investment above $800,000 for 2008 and 2009, above $2 million for 2010 and thereafter (as indexed).<a href="#_ftn11" name="_ftnref11">¹¹</a> In 2017, the $2 million amount was indexed to $2,030,000 ($2,010,000 in 2016).<a href="#_ftn12" name="_ftnref12">¹²</a><br /> <br /> The 2017 tax reform legislation increased the maximum amount that can be expensed during the tax year to $1,000,000,<a href="#_ftn13" name="_ftnref13">¹³</a> and increased the phase-out threshold amount from $2,000,000 to $2,500,000.<a href="#_ftn14" name="_ftnref14">¹⁴</a> These amounts are indexed for inflation to $1,250,000 and $3,130,000 in 2025 ($1,220,000 and $3,050,000 in 2024, $1,160,000 and $2,890,000 in 2023, $1,080,000 and $2,700,000 in 2022 and $1,050,000 and $2,620,000 in 2021).<a href="#_ftn15" name="_ftnref15">¹⁵</a><br /> <br /> The amount expensed is limited to the aggregate amount of taxable income derived from the active conduct of any trade or business of the taxpayer. An amount that is not deductible because it exceeds the aggregate income from any trade or business may be carried over and taken in a subsequent year. The amount carried over that may be taken in a subsequent year is the lesser of (1) the amounts disallowed because of the taxable income limitation in all prior taxable years (reduced by any carryover deductions in previous taxable years); or (2) the amount of unused expense allowance for such year. The amount of unused expense allowance is the excess of (1) the maximum cost of property that may be expensed taking into account the dollar and income limitations; over (2) the amount the taxpayer elects to expense.<a href="#_ftn16" name="_ftnref16">¹⁶</a> Married individuals filing separately are treated as one taxpayer for purposes of determining the amount that may be expensed and the total amount of investment in such property.<a href="#_ftn17" name="_ftnref17">¹⁷</a><br /> <br /> The dollar limit applies to partnerships and S corporations and to their partners and shareholders (to the extent the deduction is allowed (see IRC Section. 179(d)(8))). A partner or S corporation shareholder will reduce his or her basis in the partnership or S corporation to reflect the share of the cost of property for which an election to expense has been made whether or not such amount is subject to limitation at either the entity or partner/shareholder level.<a href="#_ftn18" name="_ftnref18">¹⁸</a> Also, the partnership or S corporation will reduce its basis in the property by the amount of the deduction allocable to each partner or shareholder without regard to whether such individuals can use all of the deduction allocated to them.<a href="#_ftn19" name="_ftnref19">¹⁹</a> Recapture provisions apply if the property ceases to be used predominantly in a trade or business before the end of the property&rsquo;s recovery period.<a href="#_ftn20" name="_ftnref20">²⁰</a> Also, amounts expensed under such an election are treated as depreciation deductions for purpose of recapture on sale or disposition (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7904">7904</a>).<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect;&sect; 168(k)(2)(A)(ii), 168(k)(2)(E)(ii).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. See IRC &sect; 168(k)(5).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. See IRC &sect; 168(k)(5), as amended by ATRA &sect; 331.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>. See IRC &sect; 168(k)(2).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>. IRC &sect; 168(k)(6)(A).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>. IRC &sect; 168(k)(8).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>. IRC &sect; 168(k)(10).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>. IRC &sect; 179, as amended by ATRA &sect; 315, PATH &sect; 143 and Pub. Law No. 115-97.<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>. Treas. Reg. &sect; 1.179-1(h)(1).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>. IRC &sect; 179(b)(7), as amended by ESA 2008, ARRA 2009, HIREA and ATRA.<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>. IRC &sect; 179(b)(7), as amended by ESA 2008, ARRA 2009, HIREA and ATRA.<br /> <br /> <a href="#_ftnref12" name="_ftn12">12</a>. Rev. Proc. 2016-14, Rev. Proc. 2017-58.<br /> <br /> <a href="#_ftnref13" name="_ftn13">13</a>. IRC &sect; 179(b)(1).<br /> <br /> <a href="#_ftnref14" name="_ftn14">14</a>. IRC &sect; 179(b)(2).<br /> <br /> <a href="#_ftnref15" name="_ftn15">15</a>. IRC &sect; 179(b)(2), as amended by ATRA &sect; 315, PATH &sect; 143 and Pub. Law No. 115-97, Rev. Proc. 2020-45, Rev. Proc. 2021-45, Rev. Proc. 2022-38, Rev. Proc. 2023-34, Rev. Proc. 2024-40.<br /> <br /> <a href="#_ftnref16" name="_ftn16">16</a>. IRC &sect; 179(b)(3); Treas. Reg. &sect; 1.179-3.<br /> <br /> <a href="#_ftnref17" name="_ftn17">17</a>. IRC &sect; 179(b)(4).<br /> <br /> <a href="#_ftnref18" name="_ftn18">18</a>. Rev. Rul. 89-7, 1989-1 CB 178.<br /> <br /> <a href="#_ftnref19" name="_ftn19">19</a>. Treas. Reg. &sect; 1.179-1(f)(2).<br /> <br /> <a href="#_ftnref20" name="_ftn20">20</a>. IRC &sect; 179(d)(10); Treas. Reg. &sect; 1.179-1(e).<br /> <br /> </div></div><br />

<div class="Section1">An equipment leasing company may enter into a &ldquo;wrap lease.&rdquo; After entering into the basic arrangement between manufacturer and user, and having arranged financing, the equipment leasing company sells the equipment (subject to the user lease and lender&rsquo;s rights) to an unrelated third party who in turn sells the equipment (still subject to the user lease and lender&rsquo;s rights) to a partnership or trust. The partnership or trust then <em>leases</em> the equipment (still subject to the user lease and lender&rsquo;s interest) back to the equipment leasing company. This second lease to the equipment leasing company is generally for a longer term than the leasing company&rsquo;s underlying lease to the user. This lease from the investors to the leasing company is termed a &ldquo;wrap lease.&rdquo; (In effect, the second, longer lease to the leasing company is wrapped around the original lease to the user.) In this arrangement, the leasing company both leases from the partnership, trust, or directly from the investors, and in turn leases to the user. (In other words, the leasing company is a lessor with respect to the user and lessee with respect to the partnership or trust.)</div><br />

<div class="Section1">Yes. The owner of leased equipment may generally deduct each year amounts paid for interest on indebtedness incurred to purchase the equipment. The interest may be deducted only over the period to which a prepayment relates, not when prepaid.<a href="#_ftn1" name="_ftnref1">¹</a> However, the interest will generally be subject to the passive loss rules (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7902">7902</a>).<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect;&sect; 461(g)(1), 461(h).<br /> <br /> </div></div><br />

<div class="Section1">Yes, the &ldquo;at risk&rdquo; rules will apply unless the investment is in an entity taxed as a C corporation, other than a closely-held corporation (generally, more than 50 percent control by 5 or fewer owners). The &ldquo;at risk&rdquo; rules will not apply to a closely-held corporation&rsquo;s equipment leasing activities if 50 percent or more of the corporation&rsquo;s gross receipts are attributable to equipment leasing<a href="#_ftn1" name="_ftnref1">¹</a> (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8004">8004</a>).<div class="Section1"><br /> <br /> In general, the &ldquo;at risk&rdquo; rules limit the deduction an investor may claim for the investor&rsquo;s share of net losses generated by an equipment leasing program to the amount he or she has at risk in that program. The rules do not prohibit an investor from offsetting his or her share of the deductions generated by the program against the income received from that program. For a detailed explanation of the operation of the at risk limitation, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8006">8006</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8009">8009</a>.<br /> <br /> Put as simply as possible, an investor is initially &ldquo;at risk&rdquo; to the extent that the investor is not protected against the loss of money or other property he or she contributes to the program. For the specifics as to how an investor&rsquo;s &ldquo;amount at risk&rdquo; is calculated, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8005">8005</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. See IRC &sect;&sect; 465(a)(1), 465(c)(4).<br /> <br /> </div></div><br />

<div class="Section1">Cash basis taxpayers generally include rental payments in income in the taxable year in which they are actually or constructively received. Leasing programs have sometimes used deferred or stepped rent schedules in order to delay receipt of income until later years of the program, with the effect of increasing loss deductions in early years. However, lessors under certain deferred or stepped payment lease agreements entered into after June 8, 1984, are required to report rental income as it accrues, as well as interest on rent accrued but unpaid.<a href="#_ftn1" name="_ftnref1">¹</a> Agreements are subject to this rule if at least one amount allocable to the use of the property during a calendar year is to be paid after the close of the following calendar year, or if there are increases in the amount to be paid as rent under the agreement. This accrual requirement does not apply if the aggregate value of the money and other property received and to be received for use of the property is $250,000 or less.<a href="#_ftn2" name="_ftnref2">²</a> These rules are discussed in further detail in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7831">7831</a>.<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 467(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. IRC &sect; 467(d).<br /> <br /> </div></div><br />

<div class="Section1">The investor may have the following adjustments to alternative minimum taxable income (AMTI) or tax preferences in connection with investment in an equipment leasing program that passes losses and deductions through to the investor:<br /> <p style="padding-left: 40px">(1) Passive activity losses (determined by taking into account the adjustments to AMTI and tax preferences) are not allowed in calculating AMTI.<a href="#_ftn1" name="_ftnref1">¹</a></p><br /> <p style="padding-left: 40px">(2) Generally, in calculating AMTI, equipment must be depreciated using a 150 percent declining balance method switching to the straight-line method at a time to maximize the deduction over the regular recovery periods.</p><br /> Property is assigned to various <em>class lives</em> in Revenue Procedure 882.<a href="#_ftn2" name="_ftnref2">²</a> These class lives can also be found in IRS Publication 946.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 58(b).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. 1988-1 CB 785.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> The equipment leasing business provides equipment to users who want the equipment but, for various reasons, prefer not to purchase it. Ordinarily, the user arranges with an equipment leasing company to have the leasing company buy the equipment from the manufacturer and lease it to the user. The leasing company obtains financing for its purchase and generally secures the loan with a lien against the equipment and an assignment of the flow of rental income to the lender to amortize the loan. The equipment leasing company then sells the equipment (subject to the lease to the user and subject to the rights of the lender) to a limited partnership, a grantor trust, or to individual investors.<br /> <br /> In a highly leveraged program, the flow of rental income from the lease is generally used to meet debt service and there is nothing available for cash distributions. These programs anticipate that the debt will be paid off at the expiration of the initial user lease and that the property will have residual value that can be realized through further leasing of the equipment or on the sale of the property. Thus cash distributions are projected for later years. Less highly leveraged programs, or unleveraged programs, are designed to provide for cash distributions to the investors from the start.<br /> <br /> </div><br />

<div class="Section1"><br /> <br /> The primary tax benefit of equipment leasing programs is tax deferral. Deductions for depreciation, interest, and expenses offset rental income from the program and, depending on the amount of deductions, may offset income from other sources. Because an equipment leasing program will generally be a passive activity, such excess deductions (losses) may normally offset only other passive income of the taxpayer (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7902">7902</a>).<br /> <br /> Depreciation and interest deductions will decline. Consequently, while there may be tax losses in early years that offset income from sources other than the program, in later years the investor will recognize taxable income that may substantially exceed cash available from the program (&ldquo;phantom income&rdquo;). The carryover of disallowed passive losses from earlier years may reduce or even eliminate the phantom income in later years.<br /> <br /> Generally, limited partnerships and S corporations act as flow-through entities, and partners and shareholders report their share of the entity&rsquo;s income, deductions, and credits on their own tax returns (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7732">7732</a>). (Electing large partnerships have somewhat different flow-through rules than regular partnerships (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7733">7733</a>).) However, if a publicly traded partnership is taxed as a corporation, the income, deductions, and credits are reported by the partnership and do not flow-through to the partners. Electing 1987 partnerships are subject to both an entity level tax and the flow-through rules. In general, investment in a publicly traded partnership taxed as a corporation will be taxed as an investment in a corporation. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7728">7728</a> for the treatment of publicly traded partnerships.<br /> <br /> </div><br />

<div class="Section1"><br /> <br /> Yes, rental activities will generally be considered passive activities subject to the passive loss rules. Even if substantial services are provided, so that the equipment leasing activity is not considered a rental activity, the investor usually will not materially participate in the program. As a result, the investor in such a program will generally be subject to the passive loss rules (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8010">8010</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8021">8021</a>). However, an entity taxed as a C corporation typically is not subject to the passive loss rules (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8010">8010</a>).<br /> <br /> In general, the rules limit the amount of the taxpayer&rsquo;s aggregate deductions from all passive activities to the amount of aggregate income from all passive activities; passive credits can be taken against only tax attributable to passive activities. The rules are applied separately in the case of a publicly traded partnership; aggregation is permitted only within the partnership. The rules are intended to prevent taxpayers from offsetting salaries, interest, dividends, and other positive income with losses from passive activities. The benefit of the disallowed passive losses and credits is not altogether lost, but rather is postponed until such time as the taxpayer has additional passive income or disposes of the activity (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8010">8010</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8021">8021</a>).<br /> <br /> </div><br />

<div class="Section1"><br /> <br /> The amount realized on the sale or other disposition of property in excess of adjusted basis is gain; if the amount realized is less than adjusted basis, it is loss.<a href="#_ftn1" name="_ftnref1">¹</a> The basis of property is generally its cost reduced by the portion of cost which the taxpayer elects to treat as an expense (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7895">7895</a>) and by the basis adjustment attributable to any investment tax credit (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7894">7894</a>).<a href="#_ftn2" name="_ftnref2">²</a> Also, the basis is reduced each year by the amount of the depreciation taken so that the <em>adjusted</em> basis in the property reflects accumulated depreciation deductions. If depreciation is not deducted, the basis must nonetheless be reduced by the amount of depreciation allowable.<a href="#_ftn3" name="_ftnref3">³</a> If the investment tax credit is recaptured in connection with property as to which a basis adjustment was required, then the basis is increased by such recaptured amount.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> Where leased equipment has been depreciated, gain on the sale of the property must be treated as ordinary income to the extent of all depreciation deductions allowed.<a href="#_ftn5" name="_ftnref5">⁵</a> The gain in excess of the recaptured ordinary income is &ldquo;IRC Section 1231&rdquo; gain; loss is &ldquo;IRC Section 1231&rdquo; loss. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7834">7834</a> for an explanation of the treatment of IRC Section 1231 gains and losses. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="667">667</a> if the equipment is sold on the installment method.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 1001.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. IRC &sect;&sect; 1012, 1016(a).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. IRC &sect; 1016(a).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>. IRC &sect; 50(c)(2).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>. IRC &sect; 1245.<br /> <br /> </div></div><br />