Difference Between a Capital Lease and an Operating Lease

Options for Leasing Business Equipment

Capital Lease vs. Operating Lease

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Leasing equipment, including vehicles, is a common alternative to purchasing. Of the two kinds of leases – capital leases and operating leases – each is used for different purposes and results in differing treatment on the accounting books of a business.

Leasing traditionally is different from buying. When you buy a business asset like equipment or a vehicle, you are buying an asset. When you lease something, you have an expense for the use, but you don't own the property.

Several accounting and financial reporting agencies and boards regulate how businesses report their finances, including accounting for capital and operating leases. The two main agencies are the Financial Accounting Standards Board (FASB) in the U.S. and the International Accounting Standards Board (IASB) internationally.

Two terms you need to know when looking at leases: the lessor is the seller, the company offering the lease, and the lessee is the buyer.

Capital leases are considered the same as a purchase. Operating leases cover the use of the vehicle or other assets for a period of time; they are a periodic (usually monthly) expense for the lessee.

Capital Leases

capital lease is a lease of business equipment that represents ownership and is reflected on the company's balance sheet as an asset. A capital lease, in contrast to an operating lease, is treated as a purchase from the standpoint of the person who is leasing and as a loan from the standpoint of the person who is offering the lease, for accounting purposes. The terms of a capital lease agreement show that the benefits and risks of ownership are transferred to the lessee.

  • Capital leases are used for long-term leases and for items that don't become technologically obsolete, such as many kinds of machinery.
  • Capital leases give the lessee (the person who is leasing) the benefits and drawbacks of ownership, so they are considered as assets, and they may be depreciated.
  • These leases are considered as debts of the lessee.

In order to be considered a capital lease, the Financial Accounting Standards Board (FASB) requires that at least one of these conditions must be met:

  • Title to the equipment passes automatically to the lessee by the end of the lease term
  • The lease contains an option to purchase the equipment at the end of the lease at a bargain price, for substantially less than fair market value; sometimes this is a $1 purchase
  • The term of the lease is greater than 75% of the useful life of the equipment.
  • The present value of the lease payments is greater than 90% of the fair market value of the equipment.

If at least one of these conditions is not met, the lease is an operating lease. As you can see, with a capital lease you are in essence paying the cost of the car over the term of the lease.

Operating Leases

Operating leases, sometimes called service leases are used for short-term leasing (less than a year in length) and often for assets that are high-tech or in which the technology changes, like computer and office equipment. The rental cost of an operating lease is considered an operating expense.

The lessee uses the property but does not take on the benefits or drawbacks of ownership, which are retained by the lessor.

Accounting and Taxes for Leases and Lease Payments

Operating lease payments are considered expenses because there is no ownership involved. That means including the

Capital lease payments reduce the liability for the lease and interest on lease payments is a deductible business expense.

New Accounting Rules for Leases

The Financial Accounting Standards Board (FASB) issued new accounting rules in 2016 for leases - both capital and operating. The new rules require that all leases of more than 12 months must be shown on the business balance sheet as both assets and liabilities. That's why operating leases of less than a year are treated as an expense, while longer-term operating leases are treated like buying an asset.

Capital Leases and Depreciation

Because they are considered assets, capital leases may be eligible for depreciation. If you want to lease but want the benefit of depreciating the asset, check with your tax professional before you agree to a capital lease, to be sure it meets the criteria to be depreciable. Some capital leases may not be eligible for accelerated depreciation (bonus depreciation or Section 179 deductions). 

Which is Better, a Capital Lease or an Operating Lease?

As usual, it depends. A capital lease creates a debt for the lessee, and the lessor becomes a creditor.

If you are leasing a high-technology piece of equipment, you will probably have an operating lease. For example, if you are leasing copiers for your office, you probably have an operating lease. If you are leasing a piece of machinery that you intend to use for a long time, you probably have a capital lease.

For car leases, many businesses use operating leases because the cars are being used heavily and they are turned over for new models at the end of the lease. But an operating lease doesn't give you the ability to depreciate the asset. 

Benefits and Drawbacks of Equipment Leasing

In general, businesses lease equipment to fund their business without having to finance a purchase of equipment. For example, a business that uses vans or trucks for deliveries can lease those vehicles without having to get a loan or tie up funds for the purchase.

The drawbacks to equipment leasing are that leases are usually more expensive on a monthly basis and some leases are not eligible for tax-saving depreciation allowances.

Talk to your tax professional before making a decision on leasing or buying equipment, including cars, for your business.