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What is the Difference Between a Capital Lease and an Operating Lease?

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Capital Leases vs. Operating Leases - What's the Difference? Which One Should I Use for Equipment Leasing?

Leasing equipment is a common alternative to purchase. Of the two kinds of leases - capital leases and operating leases - each is used for different purposes and results in differing treatment on the accounting books of a business.

Capital Leases

  • Capital leases are used for long-term leases and for items that not become technologically obsolete, such as many kinds of machinery.
  • Capital leases give the lessee (the person who is leasing) the benefits and drawbacks of ownership, so they are considered as assets, and they may be depreciated.
  • These leases are considered as debts of the lessee.

In order to be considered a capital lease, the Financial Accounting Standards Board (FASB) requires that at least one of these conditions must be met:

  • Title to the equipment passes automatically to the lessee by the end of the lease term
  • The lease contains an option to purchase the equipment at the end of the lease for substantially less than fair market value; sometimes this is a $1 purchase
  • The term of the lease is greater than 75% of the useful life of the equipment
  • The present value of the lease payments is greater than 90% of the fair market value of the equipment.

Operating Leases

  • Operating leases, sometimes called service leases are used for shot-term leasing and often for assets that are high-tech or in which the technology changes often, like computer and office equipment.
  • The lessee uses the property but does not take on the benefits or drawbacks of ownership, which are retained by the lessor.
  • The rental cost of an operating lease is considered an operating expense.

Which is Better, a Capital Lease or an Operating Lease?
As usual, it depends. If you are leasing a high-technology piece of equipment, you will probably have an operating lease. For example, if you are leasing copiers for your office, you probably have an operating lease. If you are leasing a piece of machinery which you intend to use for a long time, you probably have a capital lease. Each type of lease is applicable to different leasing situations.

Benefits and Drawbacks of Equipment Leasing
In general, businesses lease equipment to fund their business without having to finance a purchase of equipment. For example, a business that uses vans or trucks for deliveries can lease those vehicles without having to get a loan or tie up funds for the purchase.

The drawbacks to equipment leasing are that leases are usually more expensive on a monthly basis and some leases are not eligible for tax-saving depreciation allowances.

Read more about benefits and drawbacks of equipment leasing and be sure to talk to your tax advisor before making a decision on leasing or buying equipment and the type of lease.

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