Whether you’re a farmer, a banker, or a hot dog salesman, cash is always king.
But farmers have their own unique challenges when it comes to maintaining the best cash position. When farmers purchase or improve assets, it’s not always apparent whether they should buy with cash or finance those items.So how do you make the decision between using cash and financing to buy an item?
It depends on what the expense does to the asset. Let me explain:
Expenses vs. Capitalization
The main factor in the decision between paying cash and financing is how it's deducted from your income.
Past tax laws were kind to farmers. Under Section 179 accelerated depreciation allowance, farmers could deduct up to $500,000 of expenses per year.
These terms expired last year, and under the 2015 version of Section 179, farmers can only deduct $25,000 per year at an accelerated pace. While this is certainly a game changer, and limits what farmers can buy and deduct, the principle for how to buy items remains:
If you have to capitalize the expense, you’re better off financing it.
Let’s say you spend $50,000 on precision planting machinery for your planter. The planter worked all right before, but this new technology will make your planting more precise and improve your yield.
This expense can’t be deducted, since it’s an asset improvement. If you get audited, the IRS will say it needs to be capitalized.
In this case, it’s better to finance the technology, especially with current interest rates where they are. You’ll have a liability on your balance sheet, but your cash position will remain strong. And remember, interest is 100% deductible.
If you spend $50,000 in cash, your balance sheet will reflect improved assets of $50,000, but the bank might calculate that value at $25,000 because of mark-to-market accounting laws. As with driving a new car off the lot, your technology immediately depreciates. So in this case your net worth would be lowered by paying cash instead of financing.
Your cash is worth more than that asset. Cash is more liquid. Cash has the highest value on your balance sheet, so you want to keep your cash position strong by financing the item that can’t be entirely depreciated or expensed.
But in another scenario, let’s say your combine breaks down and won’t run, and $10,000 later it’s fixed. That’s a repair expense. Not all repair expenses can be deducted in the same year as the repair, but a repair that brings your machinery from a non-working to a working condition—as in this case—can be deducted 100%.
That’s exactly the type of purchase for which it’s better to use cash, or an operating line of credit. This expense will decrease your income tax liability.
To be sure, this stuff is tricky because it doesn’t always make sense. Taxes are a big expense, but If you’re paying a lot of taxes, find out why. If you had a profitable year, you’re going to pay taxes—so be it.
But don’t buy $500,000 worth of machinery to save yourself $100,000 in tax liability. That’s not good for your net worth: it decreases it.
Another thing to take into account as you acquire an asset is the item’s depreciation schedule.
Depreciation Schedules
There are many lengths of depreciation schedules, depending on what the purchased item is.
A land improvement, for example, has to be depreciated over 15-20 years. Let’s say you put drain tile on your farms. That expense can’t be deducted that year; it has to be depreciated over 15-20 years, legally.
You can try to depreciate it, but if you get audited, the IRS will charge you taxes, fees, and interest. And because of high interest rates, you can expect to pay 2-3 times what you would have originally paid if you’d done everything properly.
If you want to know more about the depreciation schedules, google the Modified Accelerated Cost Recovery System. MACRS is the current tax reference used in the U.S. to depreciate capitalized costs of tangible property.
But the #1 rule for farmers is to get a good accountant who can reference the system for you.
Take a look at the chart for a 7-year MACRS. It’s complicated, down to the hundredth decimal percentage place, which is why the accountant is so important. That savings you think you got can come back and cost you a lot of money.
There are a lot of farmers who go to a land auction and buy land from a farmer who’s retiring or has financial problems, only to realize the IRS has a lien against the land because that farmer owes so much in back taxes.
When farmers get caught up trying to minimize income tax, they run the risk of using up their cash position. And, if they don’t do their taxes correctly, it can cost them huge fees from the IRS later.
The moral of the story? A good accountant is absolutely worth it.
Two Extra Tips
1) Pay your taxes- You’re better off paying your taxes and hoarding your cash. You don’t want to burn cash to pay down debt. Debt is actually a pretty useful tool for offsetting income down the road.
2) Talk to your banker- Bankers know what you can get for credit; lean on them for information as you purchase items.
Conclusion
Established farmers may already have land and machines paid off. But young farmers—ones who have farmed 15 years or less—will really need to focus on making good decisions about financing vs. cash, and being aware of depreciation schedules.
Whatever your age or experience, you have to understand your cash position. And you shouldn’t just have cash sitting in the bank either. You want your cash working for you, whether through stocks or some other investment suggested by a money manager.
For further help: EideBailley has developed a useful flowchart on how to treat expenditures related to tangible property. Follow it step-by-step to learn whether expensing or capitalizing an item will give you the best cash position.
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