Equipment financing: terms and tax treatment
This article explains how equipment financing works, the common contract terms you’ll see, and the U.S. federal tax treatment for purchases, loans, and leases. I draw on more than 15 years advising small businesses and cite current IRS guidance and other authoritative sources so you can apply these principles accurately. This is educational guidance — not personalized tax advice. Consult your CPA before filing.
Quick glossary of key terms
- Collateral: The asset (the equipment) a lender can repossess if the borrower defaults.
- Capital (finance) lease: A lease treated like a purchase for accounting and tax purposes; typically shows as an asset and liability on the lessee’s books.
- Operating lease: A lease treated as a rental expense; lessee does not record ownership.
- Depreciation: Tax deduction that spreads the cost of a purchased asset over its useful life.
- Section 179 deduction: A federal tax provision that lets businesses elect to deduct qualifying equipment costs in the year of purchase (see IRS guidance).
- Bonus depreciation: An additional first-year depreciation allowance that applies to qualifying property under federal tax law.
(Sources: IRS Form 4562 and Section 179 guidance; see links below.)
How equipment financing typically works
There are two broad paths businesses use to get equipment: buy it (often with a loan) or lease it.
- Loans and equipment-secured loans: The business borrows money to buy the equipment and usually owns it from day one. The lender often places a lien on the equipment until the loan is repaid.
- Finance (capital) leases: The lessee has most of the risks and benefits of ownership. The lease term often covers a large portion of the asset’s useful life and may include an option to buy the equipment at the end of the lease for a nominal amount.
- Operating leases: The lessor retains ownership. Monthly payments are generally treated as rental expenses and can be deductible by the business.
In my practice I’ve seen businesses choose leases to preserve cash and loans when ownership or long-term cost savings matter. The right choice depends on cash flow, balance-sheet preferences, and tax strategy.
Tax treatment: buy (loan) vs lease — the key differences
- Ownership = depreciation + interest deductions
If you purchase equipment (even if you used a loan), you are the owner. For federal income tax you generally:
- Depreciate the asset over its recovery period using the Modified Accelerated Cost Recovery System (MACRS).
- Deduct business interest on the loan as an interest expense (subject to interest-limitation rules applicable to some businesses).
- Consider a Section 179 election to expense qualifying property in year one (see IRS Section 179 Deduction).
- Potentially claim bonus depreciation in the acquisition year, if the property qualifies and federal law allows that percentage for the tax year.
How you report: use IRS Form 4562 (Depreciation and Amortization) to claim depreciation, Section 179, and any special depreciation allowance (IRS — Form 4562: https://www.irs.gov/forms-pubs/about-form-4562).
- Lease payments are usually deductible as rent
When you use an operating lease, monthly lease payments are typically deductible as an ordinary and necessary business expense. You don’t depreciate the asset because you don’t own it; the lessor handles depreciation for tax purposes. This can simplify tax filing and provide predictable deductions.
- Finance (capital) lease — treated like a purchase
A capital or finance lease is economically similar to buying. The lessee may deduct depreciation and interest components rather than simple rental expense. The specific accounting and tax treatment depends on lease terms; tax rules look at who bears risks and rewards of ownership and whether the lease transfers title or has a bargain purchase option.
- Bonus depreciation: the federal phase-down schedule
Under the Tax Cuts and Jobs Act (TCJA), bonus depreciation allowed 100% first-year expensing for qualified property placed in service through 2022, but the law phases the percentage down after 2022 (80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and 0% thereafter unless Congress acts). That schedule affects how much first-year depreciation you can claim; confirm the applicable percentage for the tax year before filing. (Source: IRS Publication 946 and TCJA summaries.)
- Section 179: immediate expensing for qualifying property
Section 179 lets eligible businesses elect to expense qualifying tangible personal property up to a statutory limit and subject to phase-outs tied to total equipment purchases. Because Section 179 is an election, you must opt in on Form 4562. Some property is ineligible; qualified improvement property, certain vehicles, and special-use property have their own rules. Note: states may conform differently to federal Section 179 rules — check your state tax code. (IRS — Section 179 deduction: https://www.irs.gov/businesses/small-businesses-self-employed/section-179-deduction)
- State tax differences (decoupling)
Many states do not fully follow federal bonus depreciation or Section 179 rules. That means a deduction you take on your federal return might be added back on your state return. Consult state guidance or your tax pro. For a more detailed read on state differences, see our glossary on Decoupling (State Taxes).
Practical examples (hypotheticals)
Example A — Buying with a loan
- Company A buys a $100,000 machine and finances it with a bank loan. They own the machine and will:
- Claim depreciation over the required recovery period under MACRS.
- Possibly elect Section 179 or bonus depreciation if it’s advantageous and the asset qualifies.
- Deduct interest paid on the loan subject to business interest expense limits.
Example B — Operating lease
- Company B leases a $100,000 piece of equipment under an operating lease. Each monthly payment is deductible as a rental expense. At lease-end, Company B can return the equipment or negotiate a new agreement.
Example C — Finance lease
- Company C enters a finance lease that transfers most ownership risks. For tax purposes, Company C treats the transaction like a purchase and depreciates the asset while deducting the interest portion of lease payments.
These simplified examples show why the chosen structure matters for cash flow, balance sheet presentation, and tax timing.
Common mistakes and how to avoid them
- Assuming lease always equals cheaper taxes: While operating leases simplify deductions, finance leases or purchases can create larger first-year deductions via Section 179 or bonus depreciation.
- Forgetting state add-backs: If your state doesn’t follow federal bonus depreciation, plan for state-level taxable income adjustments.
- Neglecting total cost of ownership: Financing fees, maintenance, insurance, and end-of-lease charges can outweigh lower monthly payments. Include those in a 5–7 year total-cost comparison.
How to choose: practical decision checklist
- Do you want ownership and possible resale value? If yes, leaning to purchase with a loan or finance lease makes sense.
- Do you prioritize lower upfront cash and predictable monthly expense? Consider an operating lease.
- Do you want immediate tax deductions? Evaluate Section 179 and bonus depreciation with your accountant.
- Will state tax rules reduce federal tax benefits? Check state conformity.
- Compare total cost of ownership: include maintenance, insurance, downtime risk, and end-of-lease buyout terms.
Documentation and tax filing tips
- Use Form 4562 to claim depreciation, Section 179, and special depreciation allowances (IRS Form 4562: https://www.irs.gov/forms-pubs/about-form-4562).
- Keep the purchase or lease contract, invoices, and proof of business use for at least as long as the statute of limitations (typically three years, but circumstances can extend that).
- Track mileage and usage for vehicle and mixed-use assets to substantiate business vs personal use.
When to involve professionals
Engage a CPA for tax elections (Section 179, bonus depreciation) and a finance attorney to review complex lease terms. In my consulting practice, accountants and equipment finance brokers together have often found a 2–5% lower all-in cost by negotiating lease-end terms and buyout options.
Useful internal resources
- For details on choosing a lease vs purchase, see our guide: Equipment Financing vs. Leasing: Which Is Right?.
- For the federal immediate-expensing rules, read: Section 179 deduction.
Authoritative sources and further reading
- IRS — Form 4562, Depreciation and Amortization: https://www.irs.gov/forms-pubs/about-form-4562
- IRS — Section 179 deduction: https://www.irs.gov/businesses/small-businesses-self-employed/section-179-deduction
- IRS — Publication 946, How to Depreciate Property: https://www.irs.gov/publications/p946
- Consumer Financial Protection Bureau — general info on commercial lending and leasing: https://www.consumerfinance.gov/
Professional disclaimer
This article is educational and reflects best practices as of 2025. It is not individualized tax or legal advice. For tax elections, personalized depreciation planning, or lease contract review, consult a licensed CPA or attorney.
