When is a machinery lease not a lease? “A true lease will not have an equal payment as the buyout, there won’t be a stated interest rate, and you won’t gain any equity in the asset,” says Tina Barrett, the executive director of the Nebraska Farm Business Inc.

So why is it important that a machinery lease be considered a true lease as described above? Because you might get yourself in trouble with the IRS declaring any transaction that does not fit this description, adds Barrett who is also a University of Nebraska.

Tax law allows leasing of farm assets as an “ordinary and necessary business expense,” she explains.

It also clearly defines what is not considered a lease but rather a Conditional Sales Contract (often called a equipment finance, capital contract or EFC) as defined by the IRS. With a finance or capital lease payments made to the lease company must be divided into interest and principal amounts, with only the interest portion being tax deductible.

Many finance or capital leases are very similar to balloon payment loans set up for three to five years. The difference is that at the end of the financial lease period the operator can still choose to either return the machine to the dealer and give up ownership or make the final balloon purchase payment. Since the finance lease is not being taxed as a true lease, the final buy-out price can be quite variable, depending on the length of the lease and size of the payments.

“In the leases I see, there are many factors that trip the IRS rules, but the most common is a lease that has a stated or imputed interest value or does not have a true fair-market value buyout schedule in the end,” Barrett explains. This is why Barrett encourages farmers considering a lease to show the lease agreement to their accountant so they they can determine how it will be handled form a tax perspective.