Can You Depreciate Leased Equipment? True Lease vs. Conditional Sale

You can depreciate leased equipment only when the IRS treats your lease as a conditional sale rather than a true rental. The classification turns on who is the tax owner of the equipment. If the arrangement functions economically like a financed purchase, you are the owner for tax purposes and you depreciate the equipment just as if you had bought it. If it functions as a rental, the lessor keeps the depreciation and you deduct each payment as rent instead.¹

How the IRS Decides Whether Your Lease Is Really a Purchase

The label on the contract does not control. The IRS looks at economic substance, and an agreement titled “lease” can be recharacterized as a conditional sale if the terms transfer the risks and rewards of ownership to you.² The overarching question is which party bears the risk of the equipment losing value and which party benefits if it appreciates.

Beyond that, any single one of the following factors is enough to convert a lease into a conditional sale:

The agreement provides that you receive title after a stated number of payments.
You have an option to buy the equipment at the end for a price well below its expected fair market value, making exercise a near certainty.
Part of each payment is designated as building an ownership interest.
Your payments substantially exceed what an unrelated party would pay to rent the same equipment.
Portions of the payments are designated as interest, or the interest component is easy to identify.
What you would pay over a short rental period is an unreasonably large fraction of the full purchase price.

Only one of these has to be present.³

Note that this tax analysis is independent of your books. Financial accounting under ASC 842 uses its own tests, and a lease often ends up classified one way for GAAP and differently for tax. Your return follows the IRS criteria regardless of what your balance sheet shows.²

If It’s a True Lease: Deduct the Payments, Skip Depreciation

When your lease qualifies as a true lease, the lessor is the tax owner and claims the depreciation. You cannot. What you get in exchange is a straightforward deduction: the full amount of each lease payment is deductible as a business expense, reported as rent on Schedule C for a sole proprietorship or Form 1120 for a corporation.³

Prepaid rent has to be spread. You can deduct only the portion applicable to the current tax year, and the balance is deducted over the period it covers. Costs paid to cancel a business lease early are deductible as well.

The tradeoff is real. You avoid tracking basis, choosing a recovery period, and picking a depreciation method, but you also lose access to the accelerated deductions available to owners, including Section 179 and bonus depreciation.

If It’s a Conditional Sale: You Depreciate Like an Owner

When the IRS treats your lease as a conditional sale, you handle the transaction as if you financed a purchase with a loan. Each payment splits into two pieces. The interest portion is deductible. The principal portion is not deductible but builds the equipment’s depreciable basis.⁴

Your depreciable basis is the equipment’s fair market value at the start of the lease. You recover that cost through the Modified Accelerated Cost Recovery System, which assigns a recovery period based on the type of equipment. A five-year period covers most office and computer equipment. Seven years applies to furniture, fixtures, and general-purpose machinery.

One caveat on the interest side: the business interest expense limitation under Section 163(j) caps the deduction at 30% of adjusted taxable income calculated on an EBITDA basis. Most small businesses with average annual gross receipts of $30 million or less are exempt.

Section 179 and Bonus Depreciation on a Conditional-Sale Lease

Once you qualify as the tax owner, you are eligible for the same first-year write-offs an outright purchaser would claim. In many cases you can deduct the entire cost of the equipment in the year it goes into service.

Section 179 Expensing

Section 179 lets you expense qualifying equipment immediately rather than depreciating it. For the 2026 tax year the maximum deduction is $2,560,000, phasing out dollar-for-dollar once total Section 179 property placed in service during the year exceeds $4,090,000.⁵ The base amounts of $2,500,000 and $4,000,000 were established by the One, Big, Beautiful Bill for tax years beginning after 2024, with inflation adjustments starting for years beginning after 2025.⁶

The deduction cannot exceed your net taxable business income for the year and cannot create or increase a net operating loss. Anything you cannot use carries forward. Sport utility vehicles are capped at $25,000 of Section 179 expensing regardless of cost.

Bonus Depreciation

Bonus depreciation lets you deduct a percentage of the equipment’s cost in the first year on top of regular depreciation. The One, Big, Beautiful Bill permanently reinstated 100% bonus depreciation for qualified property acquired after January 19, 2025.⁷

Unlike Section 179, bonus depreciation has no dollar ceiling and no taxable income limitation. It can generate a net operating loss, which makes it useful for large acquisitions. Both deductions are claimed on Form 4562, and they stack: Section 179 applies first to reduce basis, and bonus depreciation applies to whatever basis remains.

Improvements You Make to Leased Property

Even when the equipment or space itself is under a true lease and you cannot depreciate it, improvements you pay for belong to you for depreciation purposes. If you install specialized wiring, build out partitions, or make other interior modifications to leased commercial space, you depreciate those costs.

Interior improvements to nonresidential real property qualify as Qualified Improvement Property, carrying a 15-year MACRS recovery period on a straight-line basis.⁸ The recovery period is 15 years regardless of the lease term. If your lease runs five years, you continue depreciating the improvement over the full 15. QIP also qualifies for 100% bonus depreciation under current law, so the entire cost can often be written off in year one.

Leasing From Yourself or a Related Party

A common setup involves a business owner personally holding equipment and leasing it to their own company. These arrangements draw heightened scrutiny under Section 482, which authorizes the IRS to reallocate income and deductions between related parties to reflect what unrelated parties would agree to.⁹

If the rent exceeds fair market value, the excess can be disallowed. Rent must be comparable to what an unrelated third party would pay for the same equipment under similar conditions.³ A documented appraisal or market-rate comparison before signing is the simplest way to protect the deduction.

What Happens When You Sell the Equipment Later

If your lease was a conditional sale and you claimed depreciation, disposing of the equipment triggers depreciation recapture under Section 1245. Gain is taxed as ordinary income up to the amount of depreciation you previously deducted. Only gain beyond your total depreciation deductions gets capital gains treatment.¹⁰

This is where aggressive first-year deductions can catch you off guard. If you wrote off the entire cost in year one using Section 179 or bonus depreciation and then sell three years later for a meaningful price, nearly all of the sale proceeds may be taxed at ordinary income rates rather than capital gains rates.

Sales of depreciable business equipment are reported on Form 4797. Equipment held longer than one year and sold at a gain goes in Part III for the Section 1245 recapture calculation. Equipment held one year or less, or sold at a loss, is reported in Part II or Part I respectively.¹¹

State Conformity Is Not Automatic

A federal depreciation deduction does not always flow through to your state return. Many states do not conform to federal bonus depreciation, and some limit or disallow Section 179 as well. In a nonconforming state, you may need to add back the federal bonus depreciation and substitute the state’s own schedule, which typically spreads the deduction over the full MACRS recovery period. The result is a timing difference: full write-off federally in year one, but recovery over several years at the state level. Check your state’s conformity rules before assuming the federal deduction carries.

1
Office of the Law Revision Counsel. 26 USC 167 – Depreciation
2
Internal Revenue Service. IRS Memorandum – Lease Classification Analysis
3
Internal Revenue Service. Small Business Rent Expenses May Be Tax Deductible
4
Office of the Law Revision Counsel. 26 USC 163 – Interest
5
Office of the Law Revision Counsel. 26 USC 179 – Election to Expense Certain Depreciable Business Assets
6
United States Congress. HR 1 – 119th Congress (2025-2026) – Section 70306
7
Internal Revenue Service. Treasury, IRS Issue Guidance on the Additional First Year Depreciation Deduction Amended as Part of the One, Big, Beautiful Bill
8
Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System
9
eCFR. 26 CFR 1.482-1 – Allocation of Income and Deductions Among Taxpayers
10
Office of the Law Revision Counsel. 26 USC 1245 – Gain From Dispositions of Certain Depreciable Property
11
Internal Revenue Service. Instructions for Form 4797 – Sales of Business Property