Equipment Operating Leases
There are basically two types of equipment leases: Operating leases and capital leases. Statistically, the majority of leases are capital leases and you can’t even get an operating lease for certain types of equipment.
From a taxation point of view, you basically write off your operating lease payments as an operating expense and do not show the related liability to the leasing company on the balance sheet (although it may need to be disclosed in the notes to the financial statements). With a capital lease, you have to show the liability on the balance sheet of the business and the lease payment is treated more like a loan payment whereby the implicit interest rate is deducted as an operating expensive and the value of the equipment is depreciated over time both for depreciation and capital cost allowance.
So while there are those that tout one form of lease over the other for tax purposes, its arguable if one really has a financial and taxation benefit over the other for any given scenario due to the variability in terms and deal structure from on situation to another.
The real distinction between the two is that with a capital lease, you are obligated to purchase the asset at the end of the lease term from the lessor for a stated price, typically nominal in value. With an operating lease, you do not have the same obligation to purchase and in fact are required to return the asset to the control of the lessor.
Here in lies the real value of the operating lease.
As a business owner, if you are utilizing equipment that will depreciate quickly from high utilization and/or quickly become obsolete from advances in technology, then an operating lease is something to consider.
For instance, in the trucking industry, where vehicles rapidly depreciate and will become more maintenance intensive as they get older, operating leases can be quite common. In the computer industry, where hardware goes out of date rapidly and needs to constantly be upgraded, equipment operating leases can also be available.
Keep in mind that there is an incremental cost borne into the operating lease for the vendor to be able to dispose of the asset without incurring a loss. If this wasn’t the case, the vendor wouldn’t offer this type of financing. And in industries where there is a large resale market like trucking, lessors can have a very solid system for asset liquidation that makes operating leases profitable for them to offer.
The key here is the mathematics.
If you can pencil out that the higher implicit cost of an operating lease will be offset by the long term repair and maintenance bills you will avoid, then an operating lease is something to consider.
If you do the math, and the numbers can’t add up, then you should be considering a capital lease. Too often a decision towards an operating lease is borne out of the luxury of not having to deal with older equipment and the thrill of getting new replacement equipment on a semi-regular basis versus any actual cost savings that may or may not occur.
If you’d like to go through the numbers, your best bet is to contact an equipment financing specialist and work through your scenario together before making a financing decision for an operating lease versus a capital lease or equipment loan.