Small Business

Tax Benefit of Operating Leases Vs Capital Leases

Before any business owner signs on the dotted line for a lease of a vehicle or equipment they should carefully read the terms in order to understand the tax implications of the transaction. The specific wording and terms of the contract could mean the difference between capitalizing an asset or taking a direct deduction for lease payments. Therefore, determining the classification of a lease before the lease is signed can be a crucial tax planning tool.

Capital Lease

For tax purposes, for a lease to be considered a capital lease it must meet any of the following criteria:

  1. At the end of the lease, ownership of the leased property transfers from the lessor to the lessee.
  2. At the conclusion of the lease there exist an option to buy the leased property below the fair market value at the date of termination (the option to purchase the leased property at its fair market value does not constitute a capital lease for this criteria)
  3. The term of the lease is in excess of 75 percent of the useful life of the leased property
  4. The net present value of future lease payments exceeds 90% of the fair market value of the leased property at commencement.

Now lets look at some basic examples of the above criteria to give a clearer picture of these rules

  1. If the business owner who signed the lease owns the leased property at the end of the lease term then the lease is a capital lease.
  2. If the business owner has an option to purchase the leased property at the end of the lease for an amount less than the market value at the date the lease expires (lets say $1 to purchase the equipment that has a current value of $1,000) then the lease is a capital lease.
  3. If the term of the lease is 12 years and the useful life of the leased property is 15 years (12 years/15 years = 80%) then the lease is a capital lease.
  4. If the total amount of principal on the lease is $10,000 and the market value of the leased property is $10,500 ($10,000/$10,500 = 95%) then the lease is a capital lease.

If the lease meets any of the above criteria then it is in fact a capital lease and should be capitalized and depreciated over it’s useful life. For accounting and tax purposes, capital leases are treated the same way as financed property.

Operating Lease

If a lease does not meet the criteria of a capital lease then it is automatically treated as an operating lease. The payments from that lease are considered operating expenses and are recorded on the p&l when paid or incurred.

Section 179 and Bonus Depreciation

The tax benefit of a capital lease often comes in the form of accelerated depreciation. Sec 179 and bonus depreciation allows companies to take a larger deduction for assets, regardless if the asset is fully paid with cash. This means that a piece of equipment that was leased during the year can be fully or partially deducted against income even if only a few lease payments were made.  This works well with companies who want to get the benefit of purchasing equipment but don’t want the negative impact on cash flow.

Section 179 Leased Equipment

You can deduct up to $500,00 under section 179 for most property placed in service in tax years beginning in 2016. If you purchase and place in service more than one item of qualifying property during the year, you can allocate the section 179 deduction among the items in any way, as long as the total deduction is not more than $500,000. Additionally, the total cost you can deduct each year, after you apply the dollar limit, is limited again to the taxable income. As a general rule you cannot take section 179 if you have a loss from operations.

Section 179 Leased Vehicles

You can deduct up to $25,000 of the cost of any heavy sport utility vehicle (SUV) and certain other vehicles placed in service during the tax year. This rule primarily applies to any 4-wheeled passenger vehicles between 6,000 and 14,000 pounds gross vehicle weight. However, the $25,000 limit does not apply to all vehicles. The following is a list of vehicles that are not subject to the $25,000 limitation.

  • Designed to seat more than nine passengers behind the driver’s seat,
  • Equipped with a cargo area (either open or enclosed by a cap) of at least six feet in interior length that is not readily accessible from the passenger compartment, or
  • That has an integral enclosure fully enclosing the driver compartment and load carrying device, does not have seating rearward of the driver’s seat, and has no body section protruding more than 30 inches ahead of the leading edge of the windshield.

Overview

The classification of a capital lease and an operating lease can have significant tax implications. Not all tax situations are the same so you must determine what classification is most beneficial for your business. For example, it should be noted that the tax benefits of accelerated depreciation and section 179 are taken upfront. This means that there will be less deductions to take on future taxable income in the form of depreciation. This, as well as other factors, should be taken into account when deciding on the right lease for your business.

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