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Capital Leases versus Operating Leases

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Last updated: 24 Nov, 2018
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By Jason Watson ()
Posted November 23, 2018

One of the problems facing small business owners is disguised purchase payments. This happens often when a business leases a copier (for example) for 60 months and then has an option to own the equipment after the lease term expires. A true lease payment is deductible in full each month, but an installment purchase payment is only deducted to the amount of finance or interest charges.

Here is the blurb from IRS Publication 535-

Lease or purchase. There may be instances in which you must determine whether your payments are for rent or for the purchase of the property. You must first determine whether your agreement is a lease or a conditional sales contract. Payments made under a conditional sales contract are not deductible as rent expense.

Conditional sales contract. Whether an agreement is a conditional sales contract depends on the intent of the parties. Determine intent based on the provisions of the agreement and the facts and circumstances that exist when you make the agreement. No single test, or special combination of tests, always applies.

However, in general, an agreement may be considered a conditional sales contract rather than a lease if any of the following is true.

  • The agreement applies part of each payment toward an equity interest you will receive.

  • You get title to the property after you make a stated amount of required payments.

  • The amount you must pay to use the property for a short time is a large part of the amount you would pay to get title to the property.

  • You pay much more than the current fair rental value of the property.

  • You have an option to buy the property at a nominal price compared to the value of the property when you may exercise the option. Determine this value when you make the agreement.

  • You have an option to buy the property at a nominal price compared to the total amount you have to pay under the agreement.

  • The agreement designates part of the payments as interest, or that part is easy to recognize as interest.

There’s no real value added by exploding all these factors into drawn out explanations. The most common lease problem is the $1 buyout or something similar- be careful what you are getting into with leases that might be disguised as purchases. Not a huge deal, but the accounting and subsequent business deduction will be different.

In the accounting world we call this example a capital lease (as opposed to an operating lease). Here are some more signs of a capital lease to noodle on-

  • The ownership of the asset is shifted from the lessor to the lessee (you) by the end of the lease period; or

  • The lessee (you) can buy the asset from the lessor at the end of the lease term for a below-market price; or

  • The period of the lease encompasses at least 75% of the useful life of the asset (and the lease is non-cancellable during that time); or

  • The present value of the minimum lease payments required under the lease is at least 90% of the fair value of the asset at the inception of the lease.

Note all the “or’s”. Again, don’t get too caught up in the technicalities. Just understand that you might have a capital lease that needs further investigation and special handling for your accounting records. Operating leases are simple, and deducted in their entirety (such as office rent). Here is the link to the IRS Publication 535 (Business Expenses)-

www.wcgurl.com/5334

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