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Replacement strategies for farm machinery

Contributed by William Edwards Published on 21 October 2019
Equipment Repair

A complete line of machinery is one of the largest investments a farm business can make. Yet, unlike land or buildings, machinery must be constantly monitored, maintained and eventually replaced.How and when equipment is replaced can mean a difference of thousands of dollars in annual production costs. 

Costs related to the machinery line clearly have a large affect on whether farms are high profit producers. Many producers give less attention to machinery costs than other cost areas because the cash expenditures are made infrequently. And, once the investment is made, depreciation and interest (except on loans) become noncash costs and are less visible.

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General replacement strategies

There are at least four general strategies farmers can follow for replacing machinery:

1. Replace frequently. This approach minimizes the risk of breakdowns and costly repairs by trading key machinery items every few years. Even when repairs occur, they often will be covered by the original warranty. Operators who cover a large number of acres each year, and would be severely inconvenienced by extended downtime, are most likely to follow this strategy. Although this is probably a more expensive approach over the long-run, some of the extra costs are offset by fewer timeliness losses, the ability to farm more acres, and less need to invest in repair and maintenance tools and facilities.

Operators who trade machinery frequently may find that leasing or rollover ownership plans are more feasible for them than conventional purchase plans. These options are discussed later.

2. Replace something every year. A second approach is to try to replace one or two pieces of machinery every year. The goal is to spend about the same amount on new equipment each year. This avoids having to make a very large cash outlay in any one year. However, it also could result in replacing machinery before it is really necessary.

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This strategy often is used by operators who prefer to finance machinery purchases out of their annual cash flow rather than with borrowed money. It works best when the net cash income of the operation is fairly constant from year to year or when significant cash reserves are available.

3. Replace when cash is available. A third approach is to postpone major machinery purchases until a year when cash income is higher than average. This keeps the machinery purchase from cutting into funds needed for other purposes such as family living and debt servicing. It also helps to level-out income for income tax purposes, although rapid depreciation methods and the ability to use income averaging have made this less of a consideration than in previous years. The biggest disadvantage of this strategy is that it is very hard to predict when extra cash will be available. Furthermore, a machine may become seriously unreliable before the business has sufficient funds to replace it. 

4. Keep it forever. Finally, some operators simply hang on to machinery until it reaches the point where it can no longer perform its intended function and is not worth renovating. This may be the least costly approach in the long-run, but it runs the risk of a machine failing at a crucial time or having to arrange financing on short notice. The operator also must be willing to use less than the latest technology. Some older items can be relegated to less critical uses, such as keeping a second planter for a backup unit or using an older tractor for jobs such as powering an auger or moving wagons. This strategy works best for operators who have considerable flexibility in when they complete key field operations and who have the skill, patience and facilities to do their own repair and maintenance work.

Alternatives for acquiring machinery

Most farm equipment is still acquired under a conventional purchase plan. The capital may come from the purchaser’s own funds, a third-party lender or a company financing plan. 

More and more major machinery items are being leased, however. Most are acquired with an operating lease, in which a fixed annual or semi-annual payment is made for several years, after which the machine can be returned to the dealer or leasing company or purchased for a predetermined price. The lease payments are tax deductible as ordinary operating expenses.

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A finance lease is similar to an operating lease, but the operator is considered to be the owner of the machine and is entitled to take depreciation deductions. The operator still can choose to keep the machine at the end of the lease period or return it. The final buyout price can be quite variable. In effect, the finance lease is equivalent to a conditional sales contract with a balloon payment at the end. 

Another option is the rollover purchase plan, in which the operator purchases a new or nearly new piece of equipment from a dealer with the expectation that it will be exchanged for another model after one year or season. Often the purchase is financed with a company loan that accrues no interest until the date to trade. At that point a cash payment is made, sometimes based on the hours of use accumulated on the model being returned.

Both lease and rollover purchase plans minimize the direct cash outflows needed to acquire the use of a machine. The rollover plan also guarantees that the machine will be relatively new and have little or no repair cost. For this same reason, it is usually the most expensive plan.

For both a lease and a rollover, the operator will have built-up no equity interest in the equipment at the end of the agreement.

Trade versus sell and buy

Most operators replace major machinery items by trading them in to a dealer in exchange for a newer model. The cash difference paid to trade, sometimes called the "boot," depends on the trade-in value of the old machine, the list price of the new machine and the size of the discount the dealer is willing to give.

When a replacement machine is obtained by private purchase, or when the dealer does not want the trade-in item, the old machine may have to be disposed of by private sale. Of course, to sell and buy is always an option even when a trade is possible. Generally, the choice will depend on which method requires the fewest dollars. In addition, most operators find trading in an old machine to be more convenient than selling it outright.

The 2018 tax reform act eliminated "like-kind exchanges" for non-real property such as machinery. Now, when a machinery item is traded, the newly acquired item has a basis equal to its fair market value, and the traded item is considered to have been sold for an amount equal to the basis of the new item minus any cash boot paid to trade.

If the old machine is sold for more than its final tax basis, a gain is created. Usually, this is reported as recaptured depreciation and taxed as ordinary income. However, revenue in excess of the initial tax basis of the machine is taxed as capital gain. Neither of these is subject to self-employment tax.

If the machine is sold for less than its final tax basis, a capital loss is created, which can be used to offset capital gains from the sale of other assets.

Take for example a new pickup purchased for $40,000. After three years the owner has claimed depreciation of $23,400, leaving an adjusted tax basis of $16,600. She then sells the pickup for $25,000, which is $8,400 more than its tax basis. She would have to report that amount as recaptured depreciation on her next tax return.

If she had sold the pickup for only $15,000, which is $1,600 below its tax basis, she would have a capital loss equal to that amount to report. At the other extreme, if she had sold it for $45,000, she would have a capital gain of $5,000 to report, in addition to recapturing all the depreciation taken of $23,400.

Summary

Replacing farm machinery is an important and complex decision. Each farming operation must identify its most important reasons for replacing machinery and then establish a consistent pattern. Reliability, long-run costs, pride of ownership, obsolescence, need for capacity and tax savings should all be considered before making a final decision.  end mark

The full article can be viewed here (https://www.extension.iastate.edu/agdm/crops/html/a3-30.html)

PHOTO: An equipment breakdown isn't the only reason to consider replacing farm machinery. Other reasons can include need for capacity or tax savings, but many factors should be evaluated before making that decision. Staff photo.

William Edwards
  • William Edwards

  • Professor Emeritus of Economics
  • Iowa State University
  • Email William Edwards

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