Knowing Your Financing Options for Purchasing Construction Equipment
When it comes to purchasing new construction equipment, one of the most important factors to consider is the financing option that works best for your needs. Paying in cash may be the most convenient and cost-effective option as it eliminates the concerns about long-term debt, high interest rates and debt-to-equity ratios.
However, most construction companies do not have the available funds to purchase equipment outright, so they usually need to look into financing options instead.
There are currently three options available for financing equipment: short-term rental, lease and loan. In this article, we will be focusing on leases and loans. Short-term rental is a good choice when specialized equipment is only needed for a brief period, but it can be more expensive than leasing or taking out a loan. Renting is a good option in this situation because there is no long-term commitment and maintenance is covered by the rental company.
However, for most companies, long-term availability for equipment is required, which is where leasing and financing come in. Both leases and loans have their pros and cons, so the best financing option will depend on how the equipment is being used.
Purchasing With a Loan
Obtaining a loan is the most common type of financing when acquiring equipment. It was particularly popular when there were low interest rates and fast tax depreciation options. With the current rising rates, it is important to reassess this option. There are many benefits to choosing a loan for equipment financing, such as:
- It is the most cost-effective option in the long run.
- There are no usage restrictions.
- Payments can be customized to suit your needs.
- The equipment can be sold or traded at any time.
- Tax benefits such as Section 179 deduction or bonus depreciation are available.
Purchasing equipment with a loan also has some downsides, including:
- High initial cost and high down payments.
- Higher monthly interest and payment.
- Equipment can become outdated, potentially affecting resale value.
- A significant impact on cash flow
Leasing is another form of financing that has become increasingly popular recently, as owners are showing more interest in leasing than taking loans. However, it’s important to note that the rising interest rates have also affected new leases. Recently, there have been significant changes in the rules involving leases, which could greatly impact your decision when acquiring new equipment. There are two kinds of leases: finance leases and operating leases, each with its own advantages and disadvantages.
A finance lease is similar to a loan, whereas it is a long-term commitment, and the equipment can be purchased at the end of the lease term. Several requirements must be met to qualify for a finance lease. The financial lease has the following characteristics:
- Fixed payment plan based on the equipment’s useful life and fair market value;
- Lower monthly interest and payment, but longer lease terms;
- The equipment might have usage restrictions;
- The option to buy at the end of the lease term, either at FMV or a predetermined price; and
- A long-term commitment, sometimes can be longer than a loan.
An operating lease is any other lease that doesn’t qualify as a financial lease. An operating lease is like a rental for an extended period, where the equipment must be returned without the option to purchase it at the end of the lease term. The operating lease has the following characteristics:
- Flexible lease period;
- Requires the equipment to be returned at the end of the lease term;
- Does not impact the debt-to-equity ratio if it’s less than a year;
- Offers access to newer models and technology;
- Requires limited maintenance;
- Last for a short term, usually three years, but can be modified; and
- Has higher monthly payments (flexibility comes at a cost!).
The Best Option for Different Occasions
A loan is the best choice if the following conditions apply to you:
- The equipment that you plan to acquire is one of the main pieces of equipment used for most jobs that don’t require new technology.
- You want to save on the overall cost of the equipment and have the cash for the initial down payment and higher monthly costs.
- You want no restrictive usage of the equipment, and it can be customized as needed.
On the other hand, a finance lease is the best option if the following conditions apply to you:
- You want to own the equipment at the end of the lease.
- You want a lower impact on cash flow.
- You want a lower initial cost and monthly payment but more total payments.
Finally, an operating lease is the best option if:
- You want a new model every couple of years as the technology of that equipment is evolving constantly, and getting a newer model is needed to stay competitive in the industry.
- You want to minimally maintain the equipment (most maintenance often lies with the lender in an operating lease.
- You want no effect on the debt-to-equity ratio if less than a year, which is often being reviewed when applying for a loan.
When it comes to purchasing equipment for your business, paying in cash is the best option if you have the funds readily available and the equipment is crucial to your daily operations. If you ever find yourself in a position where you need to decide between getting a loan or a lease, we hope the information provided here gives you a rough idea of which option to choose. Making the right financial decision can be the difference between making a profit and breaking even, or even losing money on a job.
These financial options can also vary from case to case and from contractor to contractor, and there are many other variables that can affect which option is best for you. If you are uncertain about which option to choose or need professional advice on the potential impact on the tax or financial statement, please feel free to contact us at Dannible & McKee. We are always ready to help you with any questions you might have and provide guidance regarding your situation.
Contributing Author: Joseph A. Hardick, CPA, CCIFP, is a tax partner who has over 40 years of experience in all areas of individual and corporate income tax preparation and planning. Joe specializes in corporate tax and tax planning for manufacturing and construction companies, and he has consulted on numerous areas of income and estate tax planning for high-net-worth individuals.