If your business leases equipment under a typical lease, you generally are entitled to currently deduct your rental payments as long as you are using the leased property in your business. However, you need to be aware that, in certain situations, the Internal Revenue Service ( IRS) may deny rental deductions if it concludes that your lease is in reality an installment or conditional sale. To understand why the IRS would even care whether you characterize your acquisition as a lease or a purchase, consider the following example:
Example:
Penny's Cake Company is interested in a piece of equipment that sells for $35,000. However, instead of purchasing the equipment, Penny's negotiates to lease the equipment for three years at an annual rent of $12,000. The lease grants Penny's the option to purchase the equipment at the end of the lease for $2,000. The fair rental value of the equipment is only $5,000. Why would Penny's and the leasing company do this?
From Penny's perspective, leasing the equipment allows it to effectively recover the equipment's cost over three years via its deductions of the rental payments. If it had purchased the equipment, it likely would have recovered the cost over five years via depreciation deductions. The IRS really frowns upon the improper acceleration of deductions.
From the lessor's perspective, leasing the equipment allows it to spread its recognition of income over the three-year lease period. The improper deferral of income is another thing the IRS dislikes.