Are you thinking about building a farm shop, or maybe just adding a cold storage building for farm machinery? If so, there are many decisions that will need to be made. From site location and size to building materials and contractors, those are just a few of the items that will need to be considered. Outside of those building-specific items, there are other equally important financial decisions from a credit and tax perspective that should be addressed in the planning stages as well.
Many times, when discussing the financial side of constructing a new farm building it can revolve solely around how much money can be borrowed and what the terms are. The reality is it should also include evaluating working capital, loan and lease options, impacts to cash flow, and how it is handled on a tax return. While that may seem excessive and overwhelming, the choices made will have consequences that could affect the farm operation if not prepared.
The decision of using working capital or a loan versus a lease will be different for every operation depending on their overall financial position and goals. Using working capital for the construction of a new building will decrease the amount of the project that would need to be funded with loan or lease proceeds. Therefore, that potential loan or lease payment would be lower, interest and lease expenses would be reduced, and less collateral would be needed to secure the loan or lease. After determining the amount of working capital to use, loan and lease options can be explored.
While they do have similarities, there are some differences that might make one or the other more beneficial depending on the situation. The overall cost of a loan versus a lease is usually comparable, but there are certain scenarios that may push one option in front of the other. That could range from interest rate environment to options for deducting on a tax return, which is why it is important to look at both options. Collateral is another item that has several options if using a loan or a lease. Whether you are looking to use only the new building, pledging real estate, using an existing line of machinery, or qualifying for an unsecured loan, there are many options available. Perhaps one of the biggest differences in a loan and lease is how they are handled for tax purposes.
The process of reviewing a loan versus a lease should be done in conjunction with reviewing how the construction of a new building will be deducted on a tax return. While the use of working capital or loan proceeds would be deducted through depreciation and interest expense, a lease would initially deduct actual lease payments and then move to depreciation after the lease buyout is completed.
Another important reason to review tax options is because of the ever-changing tax code and what the rules allow on a tax return in any given year. For example, currently, farm buildings with construction completed and placed into service prior to January 1, 2023, are eligible for 100% bonus depreciation. This means that a building placed in service prior to that date could potentially be 100% deducted in the first year. However, as the tax laws are written today, it also means if it is completed in a later year, it could be eligible for a lower amount or perhaps no bonus depreciation at all. This could increase the desire for an operation to look at using working capital or a loan to fund the purchase of a farm building in one year but be more interested in a lease in another year. The use of bonus depreciation on farm buildings compares to deducting using normal depreciation over the building’s 20-year useful life for tax purposes. As stated earlier, initially depreciation does not apply for leases, and instead, the lease payments would be deducted. This is often advantageous if compared to normal depreciation. It typically allows a larger amount of the building cost to be deducted more quickly. Every farm operation manages its tax liability differently, so there is no one size fits all plan to execute when constructing a new building. Therefore, it is crucial to involve your tax specialist in the planning stages as well.
Whether in the process of building or thinking about building on the farm, it is important to explore all avenues and how they can impact the farm operation. Having a good handle on both credit and tax will ensure the best decisions are made.
Contact a local AgCountry office to speak with a loan officer and a tax specialist today about loan and lease options.