How to Calculate Depreciation on Leased Equipment
As your business's assets age, the generally accepted accounting principles (also known as GAAP) require that you depreciate them. Every year, you expense some of their value to reflect aging and obsolescence. Even if you lease equipment rather than buying it, you may have to report depreciation of rental equipment as a business expense.
You account for lease depreciation as if you owned the asset. Usually, that means a straight-line method where you subtract a set amount every month based on the total value of your payments to the lessor.
Like a lot of accounting's accepted principles, the rules on leases have changed over time. Up until 2019, GAAP distinguished between an operating lease, which you don't depreciate, and a capital lease, which you do. The tests for capital leasing included whether you took out a lease-to-own option and whether you were paying close to the value of the lease asset.
Under the new accounting rules, the two classes are the finance lease and the operating lease. The standards for qualifying as a finance lease are broader, so you'll probably need to expense lease depreciation on many more leased assets. If you meet any one of five standards, your contract is a finance lease, and you have to expense lease depreciation:
- The lease transfers ownership to you at the end of the lease term.
- The lease gives you an option to purchase, and you're reasonably certain you'll take the option.
- The lease term covers most of the asset's useful life. The exception is if you start leasing when the item is already near the end of its lifespan.
- The value of the lease payments equals or exceeds the value of the asset. This is a change from the capital lease rules because it doesn't have a specific value threshold to meet.
- The asset is so specialized that the lessor won't be able to use it elsewhere once your lease ends.
Suppose your construction company takes out a lease on a new backhoe worth $25,000. Your lease runs for four years, and you pay the lesser $500 a month. To take out a $25,000 four-year loan from the bank at current interest rates, you'd pay 4.5%.
The first step is to calculate the present value of the lease, a measure of what four years of future payments are worth to you now. This is the trickiest part of the formula, but you can use Excel or online calculators to figure it out. Once you know the present value, you know whether your lease meets the fourth of the five finance-lease tests.
Assuming the deal qualifies as a finance lease, you'd report 1/48 of the present value as depreciation every month in your ledgers. When the lease ends, you'll have paid off the entire value. You report monthly depreciation on the income statement and accumulated depreciation on the balance sheet.
GAAP depreciation in your ledgers is different from using depreciation of rental equipment as a tax deduction. The IRS rule is that you claim depreciation on leased equipment if your contract is a lease-to-own arrangement. If it's a not-to-own lease, you deduct the payments as a regular business expense, even if the lease meets GAAP's five-fold test for a finance lease.
The most important part of determining whether the lease contract is lease-to-own is whether you and the lessor intend for you to buy the asset. However, the IRS lists several other standards if there's any dispute:
- Does part of each lease payment go toward purchasing the asset?
- Do you get a title after a certain number of payments?
- You have a short-term lease, and you're paying close to the purchase price for the asset.
- The lease terms are way above the fair rental value.
- The lease allows you to eventually buy for a very small payment.