Leasing offers businesses a cost-conscious option to procure necessary equipment, property, and technology without having to make an outright purchase. Most business owners seeking a leasing solution have two choices: a capital lease or an operating lease. Like most financing options, not all leasing models and terms are alike. Understanding the differences between a capital lease and operating lease can ensure you make a decision that helps your business save money, grow its operations, and attain both short- and long-term goals.
Capital and Operating Leases: Recognizing Some of the Biggest Differentiators
Capital and operating leases are marked with several essential differentiators, such as:
Transfer of Ownership
Many executives equate leasing with renting; they assume they will make monthly payments for the temporary use of needed equipment and machinery. This is not always the case. An operating lease typically does not automatically transfer the title of the goods to the lessee at the end of the agreement. However, a capital leasing solution does provide for the transfer of ownership of designated goods at the end of the lease term.
Most operating leasing strategies don’t have an automatic clause for ownership at the end of the contract. Once the term ends, the asset returns to the financing entity. Capital leases allow lessees to purchase the asset at a price point that’s lower than fair market value.
Estimated Useful Life
Some leased corporate assets have an expected lifespan that stretches over several decades, while other items may only be used for a few years before becoming obsolete. The IRS has designated rules and regulations to determine the approximate useful life of an item, which can be used when creating leasing terms. Generally, if the duration of your leasing strategy lasts at least 75 percent of the item’s established useful life, it’s a capital lease. If the term is shorter than 75 percent of its total useful life, it’s an operating lease.
Fair Market Value
The present value of leasing payments also differs between capital and operating financing. If your lease payment terms are greater than 90 percent of the asset’s fair market value, you’re working with an operating solution. However, if at the end of your contract, you’ve only paid out a small percentage of the item’s current valuation, you’re likely utilizing a capital lease solution.
Understanding the Benefits of Capital Leases
Knowing the significant differences between these two standard leasing options is an important first step in designating the right choice for your operations. However, it’s also essential to recognize some of the specific benefits of each before making a final decision.
Capital leases deliver a diverse range of financial advantages to business owners across multiple industries. This leasing strategy allows companies to stretch out the financing terms over an extended period and offers options for an automatic title transfer or final purchase at price points lower than fair market value for the ultimate “try before you buy” experience. Additionally, purchasing the assets at a reduced cost provides a budget-conscious way to keep business moving forward without unnecessary internal interruptions. Most importantly, if you don’t want to acquire the equipment at the end of the contract, you can enjoy the convenience of walking away from the contract without having to sell the asset.
Finally, capital leases typically reduce a lessee’s overall debt ratio, helping to protect cash flow as well as maintain and grow current business operations. These monthly payments aren’t tax-deductible. However, any interest paid throughout the term of the contract is typically considered a tax-deductible expense. Businesses can also sometimes depreciate leased equipment, which can further increase overall tax benefits.
Understanding the Benefits of Operating Leases
Most operating leases provide businesses with an opportunity to rent equipment that may prove too costly for an outright purchase. These leases generally cover any repairs and maintenance needs, which can be beneficial for items with extensive upkeep requirements or that may endure heavy use throughout the contract. Additionally, operating lease payments are usually considered tax-deductible expenses. It’s important to note that both capital and operating leases have different tax requirements, making it critical to discuss your specific contract terms with a qualified tax professional to optimize eligible deductions and claims.
Still Not Sure What Leasing Option Makes Sense For Your Needs?
We can help. AvTech Capital’s team of financial specialists partners with business owners in every industry to develop customized leasing solutions that maintain and grow their operations. Contact us today to learn more.