If your business depends on functioning equipment, you’ll likely need to replace your go-to gear after some time. Watching that tractor break down mid-harvest or your snow plow refuse to start in the dead of winter isn’t just a heartbreaking sight, it’s a dent in your income. When it comes time to update, however, buying the equipment outright doesn’t have to be your only option. Equipment lease financing lets small business owners invest in business growth while holding on to their working capital. Our guide on equipment leasing basics will get you ramped up on all your options. There are many different leasing contracts to choose from and the right fit depends on your goals and situation.
By reading through this guide, you should feel comfortable with the common terms in a leasing agreement, the types of leases available and when they make sense, as well as strategies for maximizing the financial and tax benefits from your lease.
What Is Equipment Leasing?
An equipment lease is a long-term rental agreement for an asset. You set up a contract with the owner of a piece of equipment where you agree to make regular payments, and in exchange, they let your business use the equipment during the lease. A lease describes an agreement that lasts 12 months or longer, whereas something shorter than that is called an equipment rental.
Some leases are also designed so that your business pays off the equipment and owns it by the end of the contract. They’re a way to finance a purchase as well as rent equipment. We will cover these types as we get beyond the equipment leasing basics below.
Equipment Leasing Basics: What Does Lessor Mean? What Is a Lessee?
A lease will always have at least two parties: the lessor and the lessee. The lessor is the person or business that owns the equipment. The lessee is the person or business renting the equipment. The lessee will make payments to the lessor throughout the contract. At the end, the lessee will either return the equipment to the lessor or they could buy the equipment if this was part of the contract.
Depending on your arrangement, you could have additional parties involved. For instance, if you work with an equipment lease financing company, you’ll provide them with a quote from the manufacturer or owner of the equipment, and they will handle the payment to the equipment owner. You will then receive the equipment, and you’ll provide lease payments to that financing company who handled the transaction, rather than to the equipment owner.
How Is a Lease Different From a Loan?
There are some key differences between equipment leasing vs. financing the purchase with a loan. The first major difference is who owns the assets. When you take out an equipment loan, you’re borrowing money to buy the equipment yourself. With a lease, the lessor owns the equipment during the contract and you’re paying to rent from them.
With a loan, you agree to pay the money back over time with interest. You could potentially save by paying the loan back ahead of schedule because then you’ll owe less interest. In a lease, you agree to a set number of payments. You can’t save money by making a larger payment earlier in the contract because you’ve agreed to pay the full amount listed in your lease payment schedule.
An equipment lease could let you finance 100 percent of the value of the asset whereas loans may ask for a down payment. Lease payments are also fixed, meaning they stay the same month after month. On the other hand, some loans can have an interest rate which goes up and down, so what you owe each month could change.
When you take out a loan, the lender might ask you to secure the deal with collateral, a piece of valuable property besides the equipment. If you miss the payments, you might lose both the equipment and another asset. Leases are typically just secured by the equipment your business is paying to use.
What Is a Capital Lease?
There are two main categories of equipment leases: capital and operating. A capital lease is designed to eventually buy the equipment. Your business makes payments to the lessor with the plan that by the end of the contract, your business will have paid it off so you can keep it. The amount you’ll end up paying depends on the type of capital lease. We’ll look at a few types later on in this guide.
With a capital lease, your business handles any repairs and maintenance to keep the equipment running. These contracts also have a clause that require you to keep making payments even if the equipment breaks during the lease period.
The payments in a capital lease are higher because the arrangement should pay off most, if not all, of the equipment by the time the contract ends. These leases make the most sense if your business wants to keep the equipment long-term but doesn’t have the money to pay for it upfront.
What Is an Operating Lease?
An operating lease is more like a pure equipment rental agreement. In exchange for the lease payments, your business gets to use the asset during the period set out in your contract.
At the end of the operating lease period, the lessor could give you the option to buy the equipment, for its fair market value, but you are not obligated to do so. You could just return the equipment to the lessor at the end.
The monthly payments on an operating lease are lower than on a capital lease because you aren’t paying off the entire value of the asset. If you decide to keep the asset, you would need to pay more at the end of the lease.
The lessor could be more involved with the maintenance and repairs for equipment during an operating lease. It depends on the lease terms. Some operating leases require you to keep up with maintenance and in others, the lessor handles this work.
These leases tend to be better when your business does not want to keep the equipment at the end of the contract. They are a good choice if you’d like to keep upgrading to new models of an asset rather than keeping one, old version.
Types of Equipment Leases
Beyond the two broad categories, here are the most common versions of equipment lease agreements:
$1 Buyout Lease — The main type of capital lease. At the end of the payment schedule, you will have nearly paid off the equipment and will just need to pay $1 to finish the purchase. The monthly payments on this lease will be the highest because you are scheduling to pay off the equipment in-full. That’s why another name for this lease is full payout.
10% Option Lease — Under this lease, your payments will cover 90 percent of the equipment’s cost. At the end of the contract, you have the option to pay the remaining 10 percent so your business can keep the equipment. However, you aren’t obligated to and can agree to return the asset to the lessor. The monthly lease payments are lower but you’ll owe a larger payment if you decide to keep the asset at the end.
10% Purchase Upon Termination (PUT) Lease — The 10% PUT lease is similar to the 10% option lease except you are required to buy the equipment at the end. It’s written in the contract that you will pay the remaining amount and keep the asset at the end of the lease.
Fair Market Value (FMV) Lease — A FMV lease is a type of operating lease. At the end of the contract, the lessor will determine the remaining worth of the equipment, based on its market value. They will tell you how much it’s still worth and you can decide whether your business wants to pay this amount to keep the equipment.
Terminal Rental Adjustment Clause (TRAC) Lease — TRAC leases are only available for over-the-road vehicles like trucks and tractors. These leases give you more flexibility to negotiate the terms of your lease. You and the lessor can set a larger payment at the end of the contract, such as your business owing 25 percent of the vehicle’s future market value by the end. This way, your monthly lease payments would be lower because you’re leaving a larger cost for the future.
Sale Leaseback — If your business owns a valuable piece of equipment and needs cash, you can use a sale leaseback arrangement. You sell the equipment to the lessor for a lump sum of cash. Then, you enter into a lease agreement where you keep using the equipment and make monthly payments to eventually buy it back.
The 179 Tax Deduction
The 179 tax deduction allows your business to get a large, immediate tax break for buying new assets like equipment. When you lease, you might still be eligible for this tax break depending on the contract. First, let’s quickly review the 179 deduction.
When your business buys a new asset, you typically aren’t allowed to deduct the whole cost immediately. You are supposed to divide the cost over the asset’s expected useful life, as determined by the IRS. They rank assets into different categories, and equipment can last from three years up to 15 years, depending on what kind you buy.
For example, if you buy a new machine for $140,000 and it’s supposed to last seven years, you can only deduct $20,000 per year from your taxes ($140,000/seven years). Through the 179 deduction, however, you get the full tax break all at once. As of 2018, businesses can deduct up to $1 million a year for qualified purchases that fall under this deduction.
Does the 179 Tax Deduction Apply to Leased Equipment?
The 179 deduction is clear-cut when you buy the asset outright. But what about when you lease? Whether you can use this tax break depends on the type of lease.
With a capital lease, you get the 179 deduction advantage. You can deduct the entire cost of the equipment all at once, up to the IRS annual limit. You get the full deduction because the capital lease is designed for your business to eventually pay off the asset.
On the other hand, operating equipment leases do not qualify. You can deduct your monthly payments on the lease, but not the entire cost of the equipment. If you end up buying the equipment at the end of the operating lease, then you could get this deduction (but not at the start of the contract). Be sure to contact your tax advisor to review equipment eligibility and guidance for your specific situation.
How to Lease Equipment
Your first step for leasing equipment should be to figure out what your business needs and for how long, so you can decide on the length of your contract. You should also decide how much you can afford for lease payments. Keep in mind that once you enter into a lease agreement, those payments will continue until the end of the contract. You should budget for something you could reliably afford, even during a tight cash flow stretch.
Now that you know the different types of leases, ask yourself what type of contract makes the most sense. Factors to consider are whether you want to keep the equipment at the end of the lease, whether you want a larger upfront tax deduction (by using a capital lease) and whether you want to pay less per month or pay more per month to have a smaller cost at the end of the lease.
Picking an Equipment Leasing Company
Once you’ve decided on the ideal terms, you can start contacting companies that offer leases. Ideally, you should work with a company that understands your industry as well as the type of equipment you’re looking to use. Under your agreement, the lessor will need to set a value for the asset so they should understand industry standards.
Make sure their leasing terms and fees are clear so you know exactly what your business will pay, both during the contract and at the end. You should also negotiate responsibilities like maintenance.
As always, ask for references from customers who have worked with the equipment leasing company. Check the company’s background, to make sure they’ve been in business an appropriate amount of time. If you’re looking for a seven-year contract, it may not be the best idea to work with a company that just opened and doesn’t have any history with long-term leases.
Equipment Lease Financing
Remember, leasing is more than a way to rent equipment. It’s also a way to finance the purchase of equipment without paying for it all at once. In addition, you may qualify for the exact same tax benefits as if you had bought the equipment outright, using the 179 deduction.
There’s a reason 85 percent of all companies lease equipment. By following the information in this guide to equipment leasing basics, you can decide when and how your business can use this valuable financing tool.