Can You Depreciate Leased Equipment for Tax Purposes?
Understand how lease classification and tax ownership impact depreciation eligibility for leased equipment and what it means for your tax strategy.
Businesses often lease equipment instead of purchasing it outright to manage cash flow and avoid large upfront costs. A common question during tax season is whether leased equipment can be depreciated. Depreciation is typically reserved for owned assets, but certain leases may allow businesses to claim depreciation deductions.
Understanding lease classification and tax ownership determines whether depreciation is allowed. The IRS has specific criteria that dictate which party—the lessor or lessee—can claim this benefit.
Lease Classification
Leases are categorized based on their structure and financial impact, which determines their accounting and tax treatment. Classification depends on factors such as lease duration, transfer of risks, and the lessee’s control over the asset. Businesses must assess these elements to determine whether a lease is considered a finance lease or an operating lease.
A finance lease meets conditions indicating the lessee effectively controls the asset. These conditions include lease terms covering most of the asset’s useful life, a purchase option at a bargain price, or lease payments approximating the asset’s fair value. When a lease meets these criteria, the lessee records the asset and a corresponding liability on their balance sheet.
Operating leases function more like rental agreements. The lessee makes periodic payments without assuming ownership risks, and the asset remains on the lessor’s balance sheet. Instead of recognizing the asset, the lessee records lease expenses. This classification affects financial ratios, debt levels, and tax deductions.
Tax Ownership Criteria
Tax ownership determines who can claim depreciation. The IRS assesses economic realities rather than just contractual terms to establish which party has ownership benefits and burdens.
A key factor is which party bears the risk of loss if the equipment becomes obsolete or is damaged. If the lessee is responsible for maintenance, insurance, and repairs, this suggests an ownership-like relationship. Additionally, if the lessee is required to purchase the asset at the end of the lease or can acquire it for a nominal amount, tax ownership is likely assigned to them.
Another indicator is whether lease payments cover most of the equipment’s fair market value. If total payments over the lease term closely match or exceed the asset’s cost, the lessee is effectively financing a purchase rather than renting. Control over how the equipment is used, modified, or disposed of also supports tax ownership for the lessee.
Depreciation Under Finance Leases
When a lease qualifies as a finance lease, the lessee records the asset on their balance sheet and can claim depreciation deductions. The most common approach is the Modified Accelerated Cost Recovery System (MACRS), which assigns specific recovery periods—five years for computers, seven years for machinery—allowing businesses to accelerate deductions in the early years of use.
Businesses must follow IRS guidelines when selecting a depreciation schedule, choosing between the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). GDS applies in most cases, while ADS is required for assets used in tax-exempt activities or outside the U.S. The choice affects deduction timing and taxable income.
Bonus depreciation may also apply, allowing businesses to deduct a significant portion of an asset’s cost in the first year. In 2024, bonus depreciation permits a 60% immediate deduction for qualifying assets, though this percentage is set to phase out in subsequent years.
Depreciation With Operating Leases
Since operating leases function as rental agreements, the lessee does not record the leased asset on their balance sheet and cannot claim depreciation. Instead, lease payments are deductible business expenses, reducing taxable income over time.
For businesses leasing equipment under these terms, the financial impact differs from that of a finance lease. Rather than benefiting from accelerated depreciation, lessees recognize a steady, predictable expense. This simplifies tax reporting and cash flow management. If a lease includes escalating payments or upfront costs, businesses must follow IRS rules on lease accounting to ensure proper deduction timing.
Section 179 Implications
Section 179 of the Internal Revenue Code allows businesses to expense the cost of qualifying equipment rather than depreciating it over several years. However, leased equipment must meet specific conditions to qualify, primarily related to tax ownership.
To claim a Section 179 deduction, the lessee must have tax ownership of the asset, which typically occurs under a finance lease. If the lease includes a purchase option at a fixed price or is structured as a capitalized transaction, the IRS may allow the lessee to claim the deduction. In 2024, Section 179 allows businesses to deduct up to $1.22 million in equipment purchases, with a phase-out threshold beginning at $3.05 million.
Operating leases do not qualify for Section 179 deductions since the lessee does not assume ownership. Instead, lease payments remain deductible as business expenses. Some businesses negotiate lease terms with a fair market value purchase option, which could allow for Section 179 eligibility if exercised.
Reporting Depreciation
Once a business determines it can claim depreciation on leased equipment, proper reporting is required to comply with IRS regulations. Depreciation deductions are reported on tax filings using specific forms and schedules, depending on the business structure and asset type.
Corporations and partnerships typically report depreciation on Form 4562, detailing the asset’s cost, depreciation method, and recovery period. Sole proprietors and small businesses filing Schedule C also use this form. If electing Section 179 expensing, businesses must indicate this on the same form, along with any bonus depreciation claimed. Errors in depreciation calculations can trigger IRS audits or require amended returns.
Businesses must maintain detailed records of depreciation schedules, lease agreements, and supporting documentation. This includes tracking the date the asset was placed in service, annual depreciation amounts, and any adjustments due to lease modifications or early buyouts. Proper documentation ensures compliance with tax laws and provides necessary records in case of an audit.