Capital Lease vs. Operating Lease

Know when to use each for your business

Employee testing and analyzing machinery and equipment
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Leasing vehicles and equipment for business use is a common alternative to buying. The two kinds of leases—capital leases and operating leases—each have different effects on business taxes and accounting.

This article will discuss the details of both leasing options to give you information for making leasing decisions.

Key Takeaways

  • Capital leases transfer ownership to the lessee while operating leases usually keep ownership with the lessor.
  • For accounting purposes, short-term leases under 12 months in length are treated as expenses and longer-term leases are capitalized as assets.
  • For tax purposes, operating lease payments can be written off as expenses during the term of the lease.
  • Operating leases are usually short-term for assets subject to becoming obsolete, while capital leases are mainly used for longer-term assets.

How Does Equipment Leasing Work?

Businesses lease property for a variety of reasons:

  • Maintaining a positive cash flow
  • Preserving capital
  • Getting financing
  • Keeping technology up to date

In all leases, the lessee acquires an asset, called a right of use (ROU), and a liability (the obligation to make lease payments).

Capital leases are considered the same as a purchase for tax and accounting purposes. Operating leases cover the use of the vehicle, equipment, or other assets, making payments during the lease term.

Be careful when considering a lease document. The IRS doesn't always consider a lease a "lease." It's a lease for tax purposes if the terms of the lease document meet IRS regulations, not what the lease is called.

New Accounting Rules for Leases

The Financial Accounting Standards Board (FASB) issued new accounting rules in 2016 for leases. 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 expenses, while longer-term leases are treated like buying an asset.

How Capital Leases Work

A capital lease is a lease of business equipment that represents ownership, for both accounting and tax purposes. The terms of a capital lease agreement show that the benefits and risks of ownership are transferred to the lessee.

Accounting for Capital Leases

For accounting purposes, a capital lease (sometimes called a "finance lease") is reflected on the company's balance sheet as an asset, with a value determined by the regulations for setting a cost basis for the asset.

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

In order to be considered a capital lease, the 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 does not exceed 75% of the useful life of the equipment.
  • The present value of the lease payments does not exceed 90% of the fair market value of the equipment

With a capital lease, you are essentially paying the cost of the car or equipment over the term of the lease.

Taxes for Capital Leases

For tax purposes, a lease is considered a capital lease when the amount of the lease is $50,000 or more, the useful life of the asset is two or more years, and the lease meets at least one of these criteria:

  • Transfers owner of the personal property to the lessee by the end of the lease term
  • Contains an option to buy at a bargain price
  • The lease term is 75% or more of the estimated useful life of the property
  • The Net present value of the property is 90% or more of the fair market value of the property

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). 

How Operating Leases Work

Operating leases are formed by a lease agreement, and the lessee doesn't own the property being leased. The owner of the property transfers only the right to use the property, and the lessee returns the property to the owner at the end of the lease.

For tax purposes, operating lease payments are similar to interest payments on debt; these payments are considered operating expenses on the business tax form for the year.

For accounting purposes, operating leases aren't shown on the business balance sheet, but the lease payments are included on the business profit and loss statement.

In an operating lease, the lessee must maintain the property and return it or an equivalent at the end of the lease in as good a condition and value as when leased.

Which Should You Use for Your Business?

Capital leases are used for long-term leases and for items that don't become technologically obsolete, such as buildings and many kinds of machinery. If you are leasing a piece of machinery that you intend to use for a long time, you probably have a capital lease.

If you are leasing a high-technology piece of equipment (copiers for your office, for example) you will probably have an operating lease.

Many businesses use operating leases for car leases because the cars are used heavily and they are turned over for new models at the end of the lease.

Benefits and Drawbacks of Equipment Leasing

In general, businesses lease vehicles and 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 operating 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.

Frequently Asked Questions (FAQs)

How do you convert an operating lease to a capital lease?

The conversion process is called "capitalizing" the lease, by turning the cost of the operating lease into a capital asset. It's possible to convert an operating lease to a capital lease, but it's complicated. You will need to estimate the value of the operating lease, and compute the present value of capital lease payments at the time of the conversion.

You may also need to buy insurance to guarantee that the asset will have a specified value at a future date. Get help from a financial institution and your attorney for this process.

How do you record an operating lease?

A lessee (the party leasing the asset from a lessor) records the operating lease by including all lease payments for the year on the income statement as an operating expense. It's also recorded as an operating expense for tax purposes.

How do you record a capital lease?

To record a capital lease in your business accounting system, you must first determine whether the business owns the leased item. If the lease is classified as ownership, the item is recorded as an asset on the balance sheet at its original cost (called cost basis).

The current and accumulated expenses for the lease are amortized, with part of the cost written off as an expense for the term of the lease.

Make sure you include all the details of a capital lease to demonstrate the legitimacy of the lease.