Can You Write Off Lease Payments for Your Business?

Many businesses choose to lease assets like vehicles, equipment, or office space instead of purchasing them outright. This decision often involves lower upfront costs and greater flexibility. A significant benefit of leasing for businesses is the potential to deduct lease payments for tax purposes, reducing taxable income and providing financial advantages.

Distinguishing Lease Types for Tax Purposes

The Internal Revenue Service (IRS) classifies leases into two main types for tax purposes: operating leases, also known as “true leases,” and finance leases, which are treated as purchases. The tax treatment of lease payments differs significantly based on this classification. An agreement is considered a finance lease if payments are applied toward purchase or entitle the taxpayer to acquire the property under advantageous terms.

The IRS uses specific criteria to determine whether a lease is an operating lease or a finance lease. A finance lease is indicated if the agreement transfers ownership to the lessee by the end of the term, contains a bargain purchase option, has a lease term equal to or greater than 75% of the property’s economic life, or if the present value of lease payments equals or exceeds 90% of the property’s fair market value. An operating lease allows the lessee to use the equipment without gaining equity or ownership, with the lessor retaining ownership.

The distinction between these lease types is important because it dictates how a business can deduct costs. For an operating lease, payments are deductible as rent expenses. For a finance lease, payments are not deductible as rent; instead, the business can deduct depreciation on the asset and the interest portion of the payments, similar to an owned asset.

Deducting Operating Lease Payments

Businesses can deduct payments made for operating leases as ordinary and necessary business expenses under Internal Revenue Code Section 162. An expense is “ordinary” if it is common and accepted in the industry, and “necessary” if it is appropriate and helpful for the business’s operation. The leased property must be used for business purposes, and payments must be reasonable.

If a leased asset is used for both business and personal purposes, only the business-use portion is deductible. Businesses must track the business-use percentage of the asset. For instance, for office space in a rented home, the business percentage can be calculated by comparing the business area to the total area of the home.

Common assets leased under operating leases include office space, machinery, and equipment. Lease payments for commercial rent are fully deductible as a business expense. Maintaining accurate records, including lease agreements and payment receipts, is important for substantiating these deductions. Self-employed individuals report these deductions on Schedule C (Form 1040) of their personal tax return.

Deducting Costs for Finance Leases

When a lease is classified as a finance lease, the IRS treats the lessee as the owner of the asset for tax purposes, even if legal title remains with the lessor. Instead of deducting the entire lease payment as a rental expense, the business can deduct depreciation on the asset and the interest portion of the lease payments. The principal portion of the lease payments is not deductible.

Depreciation allows businesses to recover the cost of property over its useful life. For most business property treated as owned under a finance lease, the Modified Accelerated Cost Recovery System (MACRS) is used. This system provides specific recovery periods and methods for various assets, allowing for accelerated deductions in the early years. Deducting depreciation is an important tax benefit, as it reduces taxable income without requiring a direct cash outflow in the year of the deduction.

The interest portion of the lease payments is also deductible under Internal Revenue Code Section 163, which allows a deduction for interest paid on indebtedness. Businesses must maintain documentation, including the lease agreement, delineating the equivalent purchase price, interest rate, and payment schedule. Documentation is needed to accurately separate the interest and principal components of each payment for tax reporting.

Special Considerations for Vehicle Leases

Leased vehicles have specific tax rules that apply to both operating and finance leases. Internal Revenue Code Section 280F imposes “luxury automobile” limitations on the amount of depreciation or lease payments deductible for certain passenger vehicles, regardless of whether the vehicle is leased or owned. For leased automobiles, these limits are applied through an “inclusion amount,” which reduces the deductible lease expense to make it comparable to the depreciation allowed if purchased. This inclusion amount depends on the vehicle’s fair market value on the first day of the lease and the lease term.

Tracking the business versus personal use of a leased vehicle is important for tax purposes. Only the business-use portion of the lease payment (for operating leases) or depreciation and interest (for finance leases) is deductible. The IRS requires records to substantiate these deductions, including the date, starting location, destination, purpose of the trip, and starting and ending odometer readings for each business trip. Acceptable mileage tracking methods include a paper logbook, spreadsheets, or GPS-enabled applications.

Taxpayers cannot use the standard mileage rate for leased vehicles if they intend to deduct lease payments. The standard mileage rate is a simplified method that incorporates an allowance for depreciation or lease payments, and using it precludes deducting actual lease payments separately. Businesses with leased vehicles must use the actual expense method, deducting the business portion of all vehicle-related costs, including lease payments, fuel, oil, maintenance, insurance, and repairs. Regardless of the method, accurate record-keeping, including lease agreements, payment records, maintenance receipts, and mileage logs, is necessary for compliance.