The following advice is specific to Australia. Most Western countries have similar structures and the broad principles are similar. However, you should consult your own advisers for specific information.
When you think about buying a new car or a new piece of equipment, you usually think about financing it and how to get the best and most tax effective deal.
There are four options for new equipment: buy it, borrow to buy it, lease it or rent it. Which should you choose? There are good and bad reasons for taking on all four options, depending on your financial circumstances and the type of equipment you are buying.
Many photographers will choose to discuss the matter with their accountants, but before doing so, it's worthwhile knowing the basics so you can properly understand the advice.
The decision-making process to follow can be like this:
• Decide whether to pay cash or borrow to buy
• Decide whether to get a bank loan, do a hire purchase agreement, or lease
• Consider the tax consequences of each
• Consider renting instead of owning.
In most cases, buying new equipment without borrowing money is the cheapest option because you are not paying extra interest or rent to a bank or finance company.
Assume you are purchasing a new digital camera outfit for $20,000. If you have the cash in the bank it will cost you $20,000. However, if you borrow the $20,000 from the bank, it might end up costing you $22,000 over three years because you are repaying the $20,000 plus interest.
There will be many studios that don't have a lazy $20,000 in their bank account, so buying for cash may not be an option. And even if you do have the cash available, you might have other expenses coming up (tax bills, holiday pay, a quiet period to get through) that will require most of the cash available. If you were to spend it on new equipment to save the interest expense, it might cause cashflow problems later on. Don't fork out big dollars without doing at least a 12-month cashflow budget to see what might happen if you were to pay cash.
If you pay cash, you won't get a tax deduction for the entire amount immediately. The deduction is available over a number of years through depreciation. However, with a digital camera you would be able to fully depreciate it over three to five years.
There are three ways you can borrow the money. You can take out a loan from the bank or finance company, you can enter into a hire purchase or commercial hire purchase (CHP) agreement, or you can take out a lease. In all three situations, you have a repayment schedule over a number of years, and for CHP and leases a large ‘balloon' payment at the end. Most aspects of a CHP and lease are negotiable, except perhaps the interest rate!
Bank loans and CHP are different from a legal point of view, but are treated the same way for taxation purposes. You claim the interest component of the repayment and you claim depreciation on the equipment.
The only difference between a loan and buying equipment for cash is the extra interest you pay. While it's true you get a bigger tax deduction when you take out a loan or CHP, you're also paying more for the equipment - so the tax deduction is just bigger, not better.
One other difference between a bank loan and CHP is that there may be a ‘balloon' or ‘residual' payment at the end of a CHP. However, bank loans can also have residuals and CHPs may have none.
For a $20,000 bank loan or CHP over three years at 7.5%, the repayment is around $622. At the end of three years, the debt will be fully repaid.
Amount Borrowed $20,000
Length of Loan 3 years
Interest Rate 7.5%
Monthly Repayment $622
Residual Payment $0
Total Repayment $22,396
Total Interest Paid $2,396
For the same loan or CHP with a $5000 residual, the monthly repayment drops to $498, a saving of $124 a month. However, at the end of the loan you will have to find $5000 and you have ended up paying $526 more interest.
Amount Borrowed $20,000
Length of Loan 3 years
Interest Rate 7.5%
Monthly Repayment $498
Residual Payment $5,000
Total Repayment $22,922
Total Interest Paid $2,922
What appears on the surface to be a better deal actually costs you more in the long run - assuming you take the loan through to completion. A residual payment is often offered because at the end of the loan period, the asset will have a value. In theory, you could sell the asset and repay the residual. Many people do this with cars, but it is not so common with cameras or lighting equipment.
If finances are tight or you're building up your business with expectations of profits in the future, including a residual at the end of the loan is a good idea because it reduces your monthly repayments, making life easier in the short term. The bigger the residual, the lower the monthly repayment.
However, beware of the barb at the end - if you don't have enough to pay the residual, you may have to refinance it which means even more interest to pay and more expense.
Residuals are always present with leases, although with computer equipment the residual may be as low as $1.00.
Leases are also treated differently for tax purposes. A three year lease for a $20,000 asset at 7.5% with a $5000 residual may cost $498 a month just like a CHP or loan, but instead of claiming depreciation and interest, you simply claim the entire lease payment. (This does not apply to luxury motor vehicles which are treated like CHP, even though they are a lease.) It makes doing your tax return easier but generally, in a low inflation environment, there is no significant difference over the life of the asset.
There are exceptions to this rule and the only way you will really know whether a lease is better than CHP or a loan is to do the sums and predict the tax consequences. However, what differences there are, are probably less than two percent of the cost of the asset.
When you borrow money from the bank or enter a CHP agreement, you own the asset. In a lease arrangement, you don't own the asset, the leasing company does. At the end of the lease, it doesn't have to sell you the asset, but as a matter of practice it will.
Some people think this can be an advantage because, if they get sick of the asset or can't afford it, they just give it back to the leasing company and walk away. While legally you can do this, there is always a clause in a good lease document that says you will be liable for any outstanding amounts. So, if you hand back your camera outfit with $8000 owing and the lease company sells it for $5000, you will have to pay the $3000 difference to the lease company.
The only way you can determine with certainty which finance option is best is to run the numbers and work out what the agreement will cost you. Generally speaking, paying cash is the cheapest way to buy equipment, followed by loans and leases with no or very small residuals, and then loans or leases with larger residuals.
There's nothing wrong with taking a loan or lease with a high residual and lower monthly repayments because it will certainly reduce your monthly cashflow requirements - just so long as you understand that having this convenience is costing you money.
The information in this article is general in nature and should not replace personal advice given by your own legal and financial advisers.