Leasing is a popular way to obtain an asset, such as a vehicle or a piece of equipment, without actually buying it. Lease payments are usually lower than the payments you’d make if you bought an asset outright, and the terms are often more flexible.
There are two types of leases: capital leases and operating leases. The capital lease vs operating lease decision can be a tough one. Each has its advantages and disadvantages, and you must understand the differences before signing a lease.
What Is a Capital Lease?
With a capital lease, the lessee essentially owns the asset and is responsible for maintenance and upkeep. A capital lease must meet one of the four following conditions:
- Ownership. The lessee receives ownership of the asset at the end of the lease.
- Purchase option. The lessee has the option to buy the asset at a below-market price at the end of the lease.
- Term of lease. The term of the lease extends for at least 75% of the asset’s useful life.
- Present value. The value of the total lease payments is at least 90% of the fair market value of the asset at the beginning of the lease.
Leasing a brand-new car, for example, qualifies as a capital lease because you can buy the car once your two- or three-year lease term is up. And your purchase option offer is often far lower than it would be if you walked into the showroom that same day and wanted to buy that straight car off the lot.
How Does a Capital Lease Work?
Just like people do, businesses use capital leases when they want the benefits of leasing and ownership. A capital lease works best for equipment with a long use life, such as heavy construction machinery. And the purchase options are excellent: Usually, it’s some nominal fee (like $1) or 10% of the purchase price. Given the purchase options, it’s worth thinking about whether you’d like to buy the equipment at the end of the lease agreement before you sign.
Some leases come with a balloon payment — a common practice in which borrowers pay off the residual value of the leased item at the end of the lease. If there is no balloon payment, a $1 buyout option is best for businesses with sufficient cash flow, as the monthly lease payments are often higher across the life of the lease. Monthly lease payments are lower with the 10% buy option, but the lease will come with a larger payment at the end of the term.
If you’re not sure you want to own the asset at the end of the lease, you can walk away and not make the balloon payment. It’s your choice, regardless of the payment structure established when you signed the lease.
What Is an Operating Lease?
An operating lease lets businesses finance equipment that’s quickly obsoleted, such as computers. An operating lease gives small business owners the benefit of flexible lease terms and the ability to trade in outdated equipment for newer models. Operating leases also generally have lower monthly payments because you’re not financing the total cost of the asset — you’re only renting the asset for a short time.
Operating leases are best when you know you don’t want to keep the asset at the end of the lease. If you wanted to keep the asset, it could get tricky. Operating leases don’t allow for transferring ownership at a bargain price once the lease is over. The lessor would have to offer to sell you the asset at its fair market value.
Capital Lease vs Operating Lease on the Books
With a capital lease, the asset is recorded on the company’s balance sheet along with the liability for the payments. You can take capital lease tax deductions for depreciation expenses and interest.
Capital leases are beneficial if you have enough income to deduct the asset’s depreciation. You can write off the depreciation using Section 179 of the IRS code.
Recent changes in accounting regulations now require operating leases that have terms longer than 12 months to document the asset and the liability of the lease payments on the company’s balance sheet. And you can write off the lease payments as operating expenses.
Upgrade Your Business
Whether you need a long-term asset or a short-term solution, you can use leases to upgrade your business. Look for companies that are transparent with their term structuring. You can find favorable and fair terms if you consider conventional and alternative options. If you know your operating and capital lease tax rules and can swing the monthly expense, you can treat your business to something shiny and new.