Capital leases and operating leases are examples of equipment leasing. A capital lease (or finance lease) allows businesses to benefit from the flexibility of a lease while adding the benefits of ownership. An operating lease trades ownership for lower monthly payments and more flexible terms as well as the ability to replace assets frequently.
When to Use a Capital Lease
Small business owners should consider using a capital lease if they will benefit from the flexibility of leasing combined with the benefits of ownership, such as depreciating the asset to offset income and a negotiated purchase price at the end of the lease term. This is ideal for businesses that intend to ultimately purchase the asset.
Some situations where you’ll want to use a capital lease are:
- Your business needs equipment with a long shelf life: If your needs include equipment that typically has a long, useful life, such as heavy machinery and manufacturing assets such as machines, tools and dies.
- Your business wants to own the equipment at the end of the lease: Capital leases generally include a purchase option, either a $1 or 10% buyout, which can be exercised at the end of the lease, making them ideal if you intend to keep the asset.
- Your business has a high income and can benefit from asset depreciation: A capital lease is considered ownership from a tax standpoint, so you can write the asset depreciation off under Section 179 to offset income.
Borrowers should consider a capital lease if they intend to ultimately own the equipment. Choosing between a $1 and 10% buyout comes down to two factors: monthly payments and balloon payment. The $1 buyout may be better for businesses comfortable with the higher payments, as it eliminates the balloon payment at the end.
Otherwise, the 10% buyout option is a great way to lower monthly payments, but businesses will need to plan for the larger payment at the end of the lease. The 10% purchase option is also a good choice for businesses that aren’t absolutely sure they want to keep the asset at the end of the lease, as it allows them to walk away from the balloon payment.
When to Use an Operating Lease
Borrowers should consider an operating lease when leasing equipment that will quickly become obsolete, such as computers or other technology at the risk of obsolescence, and when they’ll benefit from the flexibility of a lease combined with the ability to trade for newer equipment more often. This is ideal for businesses that do not want to keep the asset.
Some scenarios where an operating lease might make the most sense:
- You’re purchasing equipment that quickly becomes obsolete: If you’re purchasing equipment with a short shelf life, like computers and other technology, an operating lease will allow you to frequently update your equipment and avoid obsolescence.
- Your business needs the equipment for a shorter period of time: Operating leases are typically shorter-term contracts, so if you anticipate needing a piece of equipment for one to two years, an operating lease can help you finance the equipment for the length of time you need it.
- Your business can benefit from lower monthly payments: If cash flow is an issue, an operating lease can help you keep your monthly payments lower, since you’re not financing the total cost of the asset.
An operating lease can be a great fit for short-term needs, and is generally the right choice for businesses that don’t intend to purchase the asset at the end of the lease. It’s important to keep in mind that if that decision changes, the equipment will need to be purchased at fair market value, which will wind up costing more than opting for a capital lease in the first place.
When to Use an Equipment Loan as an Alternative
If you’re considering leasing an asset for your small business, you may want to consider an equipment loan as well. Equipment loans may have stricter underwriting requirements, but with an equipment loan, you’ll usually pay less over the course of the loan versus a comparable lease, and at the end of the term you will own the asset outright.
Consider an equipment loan if the following apply to your needs:
- You intend to own the equipment long term: If you’re not concerned with equipment obsolescence, then an equipment loan will typically be less expensive than leasing the same equipment.
- You intend to pay down the balance before the term is up: Unlike a lease, where the contract is for a certain number of fixed payments over the term, with a loan, you can save on interest charges by paying down the loan early.
Additional benefits of a loan are lower interest rates along with all the benefits of ownership. And, since you “own” the asset, you can make your own decisions regarding maintenance, as well as depreciate the asset. Equipment financing is available from traditional lenders such as banks as well as alternative lenders.
Capital Lease vs Operating Lease Comparison
Treated as an owned asset
Treated as a right-of-use asset
Lessee has the option to purchase the asset at the end of the lease term for a bargain price, often $1 or 10%
No bargain purchase option, lessee can purchase asset at fair market value at end of lease
Length of Term
Longer terms, up to a significant percentage of the useful life of the asset (5+ years)
Shorter terms, not to exceed a significant percentage of the useful life of the asset (1-3 years)
Taxes and Accounting
Lease must be reported as an asset and liability
Lessee may write off interest expense against income
As of December 15, 2019, lease must be reported as right-of-use asset and liability
Lessee may write off entire lease payment as operating expense
Lease payments to date may constitute a major percentage (90%) of asset present value
Lease payments to date must not exceed a major percentage (90%) of asset present value
How a Capital Lease Works
A capital lease is a long-term rental contract that conveys the benefits of ownership upon the lessee, such as claiming asset depreciation as well as interest expense. If a leased asset meets certain Financial Accounting Standards Board (FASB) criteria, it is considered a capital lease (or finance lease) for these purposes.
A capital lease is a lease that meets one or more of the following criteria:
- The term of the lease is greater than or equal to 75% of the asset’s useful life.
- The lease contains a purchase agreement for less than the asset’s current market value (this can be as little as $1).
- The lessee gains ownership of the asset at the end of the lease term.
- The present value of the lease payments is equal to or greater than 90% of the asset’s current market value.
With a capital lease, you can expect to negotiate monthly lease payments for the term of the lease. A capital lease is typically a longer term lease of five or more years, which can help keep payments manageable. While most capital leases contain a bargain purchase option, not all do.
How an Operating Lease Works
An operating lease is similar to a capital lease and is a contract that grants your business right of use to the asset for a defined period of time. Unlike a capital lease, an operating lease may not contain any bargain pricing to purchase the asset. Instead, the asset may be purchased at the end of the lease at fair market value.
By definition, an operating lease may not meet any of the criteria of an operating lease. As a result, operating leases are typically better suited to short-term leases of equipment that is only needed for a short period or that is quickly outdated.
With an operating lease, a residual value of the asset (what the asset is estimated to be worth at the end of the lease) is established at the outset. This is used in combination with an agreed-upon interest rate (or money factor) to determine the monthly payments for the duration of the lease.
Capital Lease vs Operating Lease: Asset Classification
A significant difference between a capital lease and an operating lease is how the asset it classified. With a capital lease, leased property is classified as an asset owned by the lessee, while with an operating lease, leased property is classified as a rented asset.
Capital Lease: Asset Classification
A capital lease requires that the business owner recognize both the asset and the liability. With a capital lease, the interest payments on the asset are recognized separately as an operating expense, while principal repayments are treated as financing expense.
Businesses that finance equipment using a capital lease can benefit from treating the asset classification by taking depreciation on the asset under Section 179. Unlike an operating lease, with a capital lease, payments to principal cannot be written off, although businesses can take a deduction for interest paid.
Operating Lease: Asset Classification
Operating leases with terms greater than 12 months must now also be recognized as an asset and liability, eliminating the ability to carry an operating lease “off the books.” Payments on principal and interest combined are recognized together as an operating expense.
Since property under an operating lease is treated as a rented asset, businesses cannot take depreciation. They can, however, write off both the interest as well as the principal as an operating expense.
Capital Lease vs Operating Lease: Purchase Options
A defining characteristic of a capital lease is the potential for a bargain purchase option, negotiated upfront and written into the lease. If a bargain purchase option exists in the lease contract, then by definition the lease is a capital lease (or finance lease). This is in contrast to an operating lease, which must not contain a bargain purchase option.
Capital Lease: Purchase Options
Some common bargain purchase options available with a capital lease are:
- $1 buyout: With the $1 buyout option, you negotiate the lease intending to pay all but $1 of the value of the asset being leased over the term of the lease. This lease typically has the highest payments, but helps you avoid a balloon payment at the end.
- 10% purchase option: The 10% purchase option allows you to lower the monthly lease payments, as well as exercise the option to purchase the equipment (for a 10% balloon payment) at the end of the lease, or walk away from the asset.
- 10% purchase upon termination (PUT): Like the 10% purchase option, the 10% PUT contains a bargain purchase price of 10%. However, in this case, there is no freedom to walk away from the payment. The 10% PUT is automatically exercised at the end of the lease.
Other bargain purchase options can be negotiated with the lessor in many cases. Additionally, capital leases are not required to contain a bargain purchase option, in which case the business can choose to buy the asset at fair market value at the end of the lease. Whenever possible, businesses should negotiate a bargain price as an option if they are signing a capital lease.
Operating Lease: Purchase Options
An operating lease cannot contain a bargain purchase option, so the only available remedy should a business decide to purchase the asset is to pay fair market value. Businesses that intend to keep the asset at the end of the lease are almost always better off negotiating a bargain price as either an option or a PUT.
Capital vs Operating Lease: Length of Terms
Capital leases and operating leases both have flexible terms, and depending on how the lease is written, payments will be due either weekly, monthly (most common), or can be structured around seasonality and quarterly payments. The length of a capital lease will typically be longer than an operating lease.
Capital Lease: Length of Terms
Capital leases are typically used to lease long-term assets, and as a result, a capital lease can have payments due for the majority of the useful life of the equipment. The length of a capital lease can be shorter, resulting in higher monthly payments, but they are normally three years to over five years in length.
Operating Lease: Length of Terms
An operating lease is often used to lease shorter-term equipment or equipment that has a short shelf life. As a result, operating lease lengths are usually shorter, and it is not unusual to see leases between one and three years in length. Operating lease terms can be lengthened to lower the monthly lease payment, but the useful life of the asset must be taken into account.
Capital vs Operating Lease: Taxes & Accounting
There are several key differences between accounting and tax treatment of a capital lease versus an operating lease. How the assets are treated, whether or not the payments can be expensed, and whether or not the asset can be depreciated all factor in when choosing which type of lease is right for your business.
Capital Lease: Taxes & Accounting
Capital leases are treated like ownership from a tax and accounting perspective. The asset is carried on your books as a right-of-use asset, and a corresponding liability is recorded as well. With the recent updates to FASB standards for classifying leases, operating leases must be recorded as an asset and liability as well, but that’s where the similarities end.
A major advantage of a capital lease is the ability to depreciate the asset. This is especially useful if you plan to purchase the asset outright at the end of the lease, as you can depreciate the entire asset upfront to offset income. This means the principal repayment may not be classified as an operating expense, but the interest paid toward a capital lease can be deducted as interest expense.
Operating Lease: Taxes & Accounting
With an operating lease, any lease terms over 12 months require that the asset be recorded as both a right-of-use asset as well as a liability, similar to a capital lease, so there is still an “off the books” advantage to operating leases under 12 months.
Since an operating lease is not intended to resemble ownership, and in fact the intent of the lease is to rent the asset for an extended period of time, all payments toward the lease principal and interest may be classified as an operating expense, deductible against income.
Capital Lease vs Operating Lease: Asset Value
A core criterion for defining a lease as a capital lease or an operating lease is the present value of the asset compared to the present value of payments made against the asset so far. The asset value may be determined by taking the fair market value of the asset whenever that value exists, or calculated based on the depreciated value of the asset.
Capital Lease: Asset Value
According to past FASB guidelines, a lease is considered a capital lease if the present value of lease payments is equal to or exceeds 90% of the present value of the asset. Under new guidelines issued by the FASB, specific criteria have been eliminated in favor of broader guidelines.
The new standard allows a lease to be classified as a capital lease if the present value of the lease payments exceed a major percentage of the present value of the asset. So, a lease that doesn’t qualify as a capital lease under any other criteria can still be classified as a capital lease if it meets this definition.
Operating Lease: Asset Value
Under past FASB guidelines, a lease could be considered an operating lease as long as the present value of the lease payments didn’t exceed 90% of the value of the asset. Under new criteria, a lease can be considered an operating lease as long as the present value of payments do not exceed a major percentage of the value of the lease.
In theory, this likely means that fewer leases qualify as operating leases, as the language creates a much more inclusive definition for capital leases (now known as finance leases). In practice, the definition of “major” is left up to the end user, so classifying a lease as operating may still be possible up to the old 90% definition.
Capital vs Operating Lease vs Equipment Loan Example
To help you evaluate which lease type is the best fit for you, let’s take a look at an example. For our purposes, we’ll look at three different methods for acquiring a needed piece of machinery for your business. For our example, the machinery cost is $100,000, and the useful life is seven years.
Comparison of Pricing Examples
Length of Term
Total Payments (Principal and Interest)
Due at End of Lease to Purchase
Total Cost to Acquire
Capital Lease Example
In our first example, we’ll assume we intend to purchase the asset at the end of the lease. We’ll use a five-year capital lease, an 8% interest rate, and a 10% bargain purchase option at the end. This allows us to keep our payments lower, as well as choose whether to buy out the lease at the end or walk away.
Total payments (including principal and interest) equal $110,625 over the life of the lease, with a monthly payment of $1,844. This leaves a $10,000 balloon payment at the end to acquire the equipment, bringing the total cost to $120,625. This example avoids financing costs on the balloon payment, which keeps payments low versus a similar lease with a $1 buyout.
Operating Lease Example
For our second example, we’ll assume we only need the equipment for three years, versus five years in our example above, and we’ll keep the interest rate the same at 8%. Since we’re not negotiating a bargain price at the end of the lease, we really don’t intend to purchase the equipment, but we’ll have the opportunity to do so by purchasing at fair market value (FMV), which for our example, will follow straight line depreciation of a seven-year asset.
Total payments equal $60,663 over the life of the lease, with a monthly payment of $1,685. In order to purchase the asset at the end of the lease, our borrower would need to pay $68,571 FMV based on straight line depreciation over three years plus a 20% markup.
In this example, we avoid overextending on an asset we ultimately don’t need or want long term. This lease has lower monthly payments and is less expensive overall assuming we walk away from the equipment. Acquiring the equipment becomes more expensive than our capital lease example, with a total acquisition cost of $129,234.
Equipment Loan Example
Our third example uses the same equipment on a five-year equipment loan with an interest rate of 8%, although we can typically expect to see lower interest rates on equipment loans. We front load 10% as a down payment so we can avoid financing that and get the closest comparison to a capital lease.
In this example, our monthly payments equal $1,740 while our total payments over the life of the loan are $104,394. The overall cost is $114,397, making this the better option for businesses that know they want to own the equipment and don’t need the added flexibility of an equipment lease.
Leasing Alternatives for Small Businesses
You may want to consider some alternatives to leasing—after all, leasing can be expensive (especially if you or your business have less than perfect credit, or no credit at all). There are also no guarantees that your business will be approved for an equipment lease, or that lease financing will be available for the type of equipment that you need.
Some alternatives to operating and capital leases are:
- Buy with cash: You might consider purchasing the asset outright, as this will allow you to save on interest and lease expenses over the life of the asset. This is a great option if you know you want to own the asset, and have the cash on hand to do so.
- Short-term rental: If you only need the equipment for a short, defined period of time (perhaps one to three months), a short-term rental can help you save on overall costs, although the rent payments are likely to be higher versus leasing.
- Traditional loan: If you need working capital for your business, or are financing other business costs, you might consider getting a small business loan to finance everything at once. Advantages include a consolidated payment as well as potentially lower interest rates.
- Line of credit: Many businesses already have a line of credit to cover other seasonal costs or liabilities when cash flow is low. Consider using your existing line of credit for quick, hassle-free equipment purchases.
Leasing Frequently Asked Questions (FAQs)
We hope we’ve answered all of your questions regarding capital and operating leases. We’ve included some of the most frequently asked questions regarding this topic below.
When should a lease be capitalized?
If you intend to depreciate the asset, and ultimately plan to assume ownership of the asset at the end of the lease term, a capital lease should be your goal. This is a great option for assets with a long useful life, and assets that your business will need long term.
Can you depreciate an operating lease?
An operating lease is not treated as ownership in the same way as a capital lease. Since you’re not meeting the criteria for a capital lease, the asset may not be depreciated the way a capital lease may.
Are lease payments tax deductible?
Lease payments are tax deductible, although the type of deduction available differs between a capital lease and an operating lease. With an operating lease, the entire lease payment may be written off to offset income as an operating expense, whereas with a capital lease, only the interest payment may be written off (as interest expense).
Are operating leases considered debt?
With the updates to FASB accounting standards, operating leases must be recorded as a right-of-use asset and businesses must also report the corresponding liability (in other words, businesses must carry the lease as debt).
Both a capital lease and an operating lease can be a great financing tool to help your business get needed equipment and other assets. Determining whether you ultimately intend to own the asset and whether the lease payments you are making will equal a major percentage of the asset value will help you choose which lease type to pursue.