A capital lease is a type of equipment lease that resembles ownership, allowing business owners to preserve cash and take advantage of depreciation on the equipment. The interest paid on a capital lease may also be written off as an interest expense. To be considered a capital lease the lease must meet specific criteria.
If an equipment ownership will be transferred at the end of the term, or if the payments will equal a significant percentage of the value of the equipment, the lease is considered a capital lease. An equipment lease also meets the criteria if the term constitutes a major portion of the asset’s useful life.
How a Capital Lease Works
A capital lease is a financial arrangement allowing small business owners to purchase the equipment they need to grow their business. It may make sense to consider a capital lease even if you can afford to purchase the equipment outright due to added flexibility allowed by leasing. With a capital lease, you can expect to make monthly payments to the principal, plus interest, for the length of the term.
Equipment that is leased belongs to the lessor until it is paid off. However, for all other purposes the equipment is treated as an asset of the lessee, allowing for a significant tax reduction, which can be useful if you need to offset high revenues. This means that you can write off interest payments as well as depreciation of the asset. It also means the asset will show up on your balance sheet, similar to an equipment loan, which can look good to potential lenders.
A lease qualifies as a capital lease if it meets any of the following Generally Accepted Accounting Principles (GAAP) criteria including:
- 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
Of course, this also means that you will also take on the liabilities of ownership. For example, with a capital lease you will be responsible for maintenance and repairs of the asset, just like if you had purchased the asset outright. In many cases, service contracts are available at an additional cost, and can potentially be rolled into the lease.
Who a Capital Lease is Right For
A capital lease is a great fit for business owners who need equipment in order to expand their business. With a capital lease, you can grow your business while preserving cash on hand, and eventually assume ownership of the asset, all while taking depreciation on the asset and expensing interest. You can then lease another asset to continue growing your business.
Some situations where a capital lease may be beneficial include:
- Businesses that need accelerated depreciation: If your business has high revenues, a capital lease allows you to accelerate your depreciation of an asset, offsetting a larger amount of income.
- Businesses with equipment with long shelf lives: If your business uses equipment that won’t be obsolete for a long time, a capital lease lets you make smaller monthly payments over time, while immediately taking advantage of ownership benefits.
- Businesses that intend to keep the asset: If you intend to keep the asset, a capital lease with a buyout option might be the right fit, allowing you to strike a “bargain price” of $1 or 10% of the asset value to buy the asset at the end of the lease.
- Businesses that need equipment but don’t have adequate cash flow: If your business can’t afford the purchase all at once, a capital lease allows you to break the cost down into smaller, more affordable monthly payments.
“A capital lease is especially attractive to Lessees with a higher revenue base because the lease is reflected as an asset on the company’s balance sheet. This allows for depreciation deductions made over time, as well as current interest expense deductions, thereby reducing the overall taxable income.”
—Suzanne Mulvihill, Attorney, Partner at Haight Brown & Bonesteel LLP
Capital Lease vs Operating Lease
There are two different types of leases, the capital lease and the operating lease. Any lease that does not meet the FASB criteria covered previously is considered an operating lease. Just like a capital lease, an operating lease allows you to acquire an asset by putting down little or no money at the beginning of the lease, and making payments as agreed (compare payments using our equipment leasing calculator) until the end of the lease.
Equipment or machinery rented through an operating lease is not considered a business asset, and cannot be listed on the business’s balance sheet. However, unlike a capital lease, with an operating lease repairs and maintenance are typically covered by the lessor. You can also write off full operating lease payments as expenses.
Operating lease vs capital lease agreements are typically more flexible, allowing for equipment to be upgraded more often, and for shorter term leases. This makes operating leases an ideal arrangement for equipment which is likely to become obsolete more quickly, as well as for equipment needs which are likely to change in the near future, or where equipment quickly becomes outdated.
Capital Lease Costs
There are various costs associated with a capital lease that small business owners need to take into account. These include down payment up to 20%, interest rates between 5% – 15%, any document fees, as well as potential site inspection fees. There is also the cost to buy the asset at the end of the lease.
Some costs you can expect to incur on a capital lease are:
- Down payment: 0-20%
- Interest: APR range between 5-15%
- Document fees: May apply and vary, check with your lender
- Site inspection fees: This fee may apply depending on the asset, and varies, check with your lender
- Buyout fee: Due at the end of the loan if you exercise this option, these fees typically range from $1 to 10% of the asset value
Down payments are not always required. It’s also important to know that interest rates can be negotiated, as can document fees. You’ll also want to make sure you understand how the buyout clause works, and if you negotiate a 10% buyout, whether the buyout is optional at the end of the lease, or required upon termination.
Types of Capital Leases
There are several different types of capital leases, generally characterized by the buyout option at the end of term, and further differentiated by the amount of monthly payments. The $1 buyout, 10% option buyout, and 10% Purchase Upon Termination (PUT).
Common Types of Leases
Type of Lease:
$1 Buyout Lease
Businesses that want to own the equipment and can afford the higher payments
10% Option Lease
Business owners looking for lower payments and flexibility at the end of the lease
10% PUT Lease
Borrowers with less than perfect credit looking for lower monthly payments
$1 Buyout Lease
The $1 buyout lease gives the lessee the option to buy out the lease at the end of the term for $1. This option typically has the highest payments, because the total value of the asset must be recouped by the lessor, before the $1 buyout being exercised.
A key benefit of the $1 buyout is it allows you to avoid a hefty payment at the end of the lease term, so this is a great option if you know you will want to own the asset at the end of the lease, and are comfortable with higher payments throughout the lease in order to avoid a balloon payment at the end.
10% Purchase Option Lease
The 10% purchase option lease allows the lessee to have lower payments for the duration of the lease, by deferring 10% of the value of the asset to the end of the lease. The final payment amount is agreed upon at the onset of the lease.
With this option, the lessee has the option to exercise the 10% buyout, or to walk away from the lease. This is a great option if you’re not sure you will want to exercise the buyout, but does create more risk for the lessor, so may come with a higher rate or stricter underwriting requirements.
10% Purchase Upon Termination (PUT) Lease
Known as the 10% PUT lease, this option works the same way as the 10% purchase option, except the buyout at the end of the lease is guaranteed in the lease contract, so the lessee is unable to walk away from it.
This is useful if you are sure you will want to purchase the asset at the end of the term, but would like lower payments for the duration of the lease. This option carries some risk for the lessee, because there is no walking away from the balloon payment at the end of the lease. So you’ll want to consider whether you will be able to afford this payment when it comes due.
Capital Lease Tax Benefits
If you’re considering a capital lease, you’ll want to be aware of the tax benefits. With a capital lease, the leased asset takes on most of the characteristics of ownership. There are several benefits to the lessee, including the ability to depreciate the asset, list the asset on your balance sheet, and expense interest.
- Asset depreciation: With a capital lease you can deduct the cost of the asset, up to $1 million, as an expense under Section 179. Or, the asset can be depreciated over its useful life span, according to IRS determination. You must exercise the Section 179 election the same year the equipment is placed in service, otherwise it is waived.
- Interest expense: Businesses with less than $25 million in annual gross receipts can deduct the full amount of interest payments to offset income earned. For businesses with over $25 million, 30% may be deducted as interest expense.
Changing Capital Lease Standards
Starting with fiscal years beginning after Dec. 15, 2019, private companies will need to start accounting for leases according to FASB Accounting Standards Update 2016-02. All other companies, including publicly traded companies, are subject to the new rules.
The update maintains two distinct lease types, however capital leases are known as finance leases under the new guidelines, while operating leases remain unchanged. The new standard requires lessees to recognize lease assets and liabilities. The net impact of this change is that there’s no longer a special incentive for businesses to use operating leases to keep an asset off the balance sheet.
Changes to lease accounting standards include:
- Capital leases now known as finance leases
- Lessees must recognize lease assets and liabilities of any lease
- All precise numbers and percentages have been removed from the guidelines and replaced with subjective criteria
- A fifth characteristic has been added, addressing specialized equipment that is of no use to the lessor at the end of the lease term
Business owners who have questions about the changes to accounting standards should consult with their accountant.
Pros & Cons of the Capital Lease
Financing equipment with a capital lease is an important decision. On the plus side, you can depreciate the asset, record it on your balance sheet, and expense the interest. On the other hand, you will be responsible for maintenance and repair, the asset might quickly become obsolete, and you’ll carry the debt on your balance sheet.
Pros of the Capital Lease
Some capital lease advantages include:
- Benefits of ownership: From an accounting perspective, a capital lease is treated like ownership, which means you will be able to show the asset on your balance sheet
- Depreciation: Since a capital lease is treated as ownership, you can depreciate the asset according to the IRS depreciation guidelines
- Interest expense: You can deduct any interest paid on a capital lease, however amount paid toward the principal is not deductible
- Free up capital: A capital lease allows you to preserve cash on hand that can be used for other business expenses
Cons of the Capital Lease
Here are some cons to keep in mind when considering a capital lease:
- Obsolescence: Assets with a short shelf life may not be a good fit for a capital lease, as you’re unlikely to want to own them at the end of the term, and may want to replace them before the lease is up
- Maintenance: With a capital lease, any maintenance or repair is typically the responsibility of you, as the owner, though in some cases service contracts are available and can be written into the lease
- Increased liabilities: The amount of debt on your balance sheet will be increased, as you’ll need to list upcoming lease payments as a liability, which may hurt your debt to equity ratio when looked at by lenders
Alternatives to the Capital Lease
If a capital lease isn’t the right option for you, there are several alternatives to consider. For example, an operating lease lets you acquire the equipment you need with lower monthly payments, and you may not be responsible for maintenance. If leasing isn’t preferable, you may want to consider the benefits of purchasing the asset outright, or obtaining a traditional loan, which might offer lower interest rates.
Here are some alternatives to consider instead of a capital lease:
If you know you want to own the asset, and have ample cash on hand, you might consider purchasing it outright. This gives you the benefits of ownership, with no additional interest payments or other fees associated with a loan or lease. You will also get the benefit of depreciation. With no loan or lease underwriting, this is also the quickest option, and poor credit or lack of time in business won’t be an issue.
If you want to own the equipment, but prefer monthly payments, an equipment loan might be the right option. Equipment loans are similar to a capital lease, however with an equipment loan you can save on interest by paying the loan off early, whereas with a lease there is typically no or significantly reduced savings. Traditional loans also give you the benefit of depreciation. Equipment loans may have more stringent underwriting criteria; however, rates may be significantly lower.
An operating lease, also known as a fair market value lease, is essentially a rental contract without an option to purchase the equipment at below market value at the end of the term. This is the right lease to consider if you’re acquiring equipment with a short life span such as technology, or expect to quickly replace the asset. An operating lease does not offer depreciation, instead allowing the lessee to write off the entire monthly payment as an operating expense.
Capital Lease Frequently Asked Questions (FAQs)
This article contains a lot of information regarding capital leases, including benefits of a capital lease, as well as downsides and alternatives. We’ll cover a few of the most frequently asked questions below.
When should a lease be capitalized?
A lease should be capitalized when your business can benefit from the ability to depreciate the asset, and intends to purchase the asset at the end of the term. This is typically the case for higher value assets that have a long useful life.
Can land be a capital lease?
In order for land to be treated as a capital lease, one of the first two GAAP criteria must be true. In other words, only a provision for transfer of title, or bargain purchase option can be considered in capitalizing the lease. For a lease in which both land and buildings are present, the two assets must be separated and capitalized individually on the balance sheet.
Are capital lease payments tax deductible?
With a capital lease, only the interest payments made on the lease can be expensed to offset income earned. In the case of an operating lease, your business can offset the complete operating expense.
A capital lease can be a great option for small business owners who need to finance equipment but want the flexibility of a lease with the benefits of ownership. You’ll want to consider the equipment being financed, the length of the lease term, and the useful life of the asset in order to make the right decision.