When operating or starting a business, leasing can be an excellent way to get your hands on key assets, like equipment, vehicles or even office technology, without purchasing these items upfront. However, like anything involving finances and your business, you have to carefully weigh your options when it comes to leasing. Although leasing enables you to try out an asset without buying it, it can also inadvertently lead you to spend more money in the long run.
In business, there are two principal forms of leasing: a capital lease and an operating lease. The differences between these two types of leasing agreements are important to understand as a business owner. Read on to find out the pros and cons of a capital lease versus an operating lease to determine which is the best option for you.
What Is a Capital Lease?
If you have an agreement in which you will own the item at the end of the lease agreement — also know as a lease-to-own agreement — then the lease is a capital lease.
Another capital lease situation is when you’re given the option to purchase the item at a discount at the end of the leasing term. If you have this option, then your lease is a capital lease.
A capital lease can also be defined by other factors. If the present value of your lease payments is greater than 90 percent of the item’s fair market value, then you have a capital lease. For example, if you lease a truck valued at $50,000 for 48 months and pay $975 a month, then the value of your lease is $46,800, which is 93.6 percent of $50,000, making it a capital lease. Similarly, if you have a lease that lasts for at least 75 percent of the item’s estimated useful life, then your lease is a capital lease.
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What Is an Operating Lease?
An operating lease can be defined essentially as a lease agreement in which there is no element of ownership in regard to the leased item. Thus, if you have a lease in which there is no transfer of ownership at the end of the agreement — so it is not a lease-to-own arrangement — then the lease is an operating lease. If there’s also no option to purchase the leased item at the end of the lease term, then it is an operating lease.
Similarly, if the value of your lease payments is equal to less than 90 percent of the item’s fair market value, then the arrangement is an operating lease. And if your lease terms are shorter than 75 percent of the item’s estimated useful life, then you have an operating lease.
Capital Lease vs. Operating Lease
With the fundamentals of a capital lease versus operating lease laid out, you can now figure out which lease arrangement works best for you. In the end, your decision depends largely on the types of assets you need for your business and the role it plays in business operations.
Pros and Cons of a Capital Lease
Perhaps the best feature of a capital lease is the ability to try out the asset before you buy it. This is great if you’re undecided on the practical value of an asset and don’t want to commit to an outright purchase of the item before you know its worth. If the item turns out not to be worth it, then you can decide against purchasing the item at the end of the lease. And if the leased item does prove worth it, with a capital lease you can then take on ownership. What’s more, you can use interest expenses on a capital lease to reduce your taxable income.
The main drawbacks with a capital lease relate to its cost and risks involved with ownership. In terms of cost, with a capital lease, you can often end up paying more in lease payments than in buying the asset right away or in payments for a typical loan agreement. Since capital leases grant aspects of ownership, you take on the associated risks. For example, if you have a capital lease on a major piece of equipment, then you’re responsible for its repair and maintenance costs.
Other minor downsides of a capital lease relate to taxes. Specifically, capital lease payments are not tax-deductible expenses, though the interest on payments is deductible. Although with many leases, the lessee can claim depreciation on the asset to reduce taxable income, some leases are not eligible for depreciation allowances on your taxes.
Related: Your Small Business Tax Guide
Pros and Cons of an Operating Lease
Many of the benefits of an operating lease come from potential savings. With operating leases, you can rent equipment that is too expensive to purchase. Like a lease from a car dealership, with an operating lease, costs for repairs and maintenance are often covered by the lessor, which can be very useful for equipment that requires significant upkeep. From a tax standpoint, operating leases are beneficial because lease payments are tax-deductible expenses.
Another benefit of operating leases is that accounting for them is generally easier than the accounting for a capital lease. Namely, most operating leases have terms of 12 months or less, with payments simply recorded as expenses on your profit and loss statement. Capital leases also have accounting features that are a bit more involved than what needs to be done for an operating lease, such as creating an additional liability account called Capital Lease Payable.
The main drawback of an operating lease is due to the lack of ownership at the end of the lease agreement. And as with capital leases, there is the danger that you will end up paying more in lease payments than you would if you purchased the asset, even if it required taking out a loan to do.
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The Bottom Line
Both capital leases and operating leases come with advantages and disadvantages. One is not inherently better than the other, but instead depends on your circumstances and what you’re looking to accomplish. What’s more, you’re likely to have more than one lease agreement for your business operations, often a combination of capital leases and operating leases.
When deciding on a capital lease versus an operating lease, the most important factors are the types of equipment or other assets you need to do business. An operating lease, in which the value of lease payments must be less than 90 percent of the item’s market value, might make the most sense for leasing a building to run your business out of. Meanwhile, for this same business, a capital lease could make the most sense for items like cars and trucks if the company depends on vehicles for its operation.
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