Should you lease equipment for your factory, warehouse, store or office, or should you buy it - - assuming Your capital is limited and you must borrow or lease to finance the purchase?

Factors Favoring Leasing

Leasing eliminates the immediate need for sizable amounts of cash up front.

  • There is no down payment, other than one or two months of prepaid rent.
  • Lease charges are spread over a comparatively long period of time; individual payments are usually lower than service on debt.

Restrictions placed on company's finances are usually fewer than what banks require.

Lease payments are deductible operating expenses for tax purposes.

When leased, equipment ownership remains with the lessor; consequently, the risk of obsolescence lies with the lessor, not you.

Lessors are frequently willing to take more credit risk than a bank might be willing to take (i.e. lease financing might be available where traditional bank loans are not).

Leasing firms are often better buyers and know the equipment better than the lessee.

Operating leases are not shown as liabilities on the balance sheet.

Factors Unfavorable to Leasing

Leasing is frequently more expensive, in the long run, than buying.

  • If you buy, you can deduct for tax purposes both depreciation and interest on the money borrowed to purchase the equipment. Alternatively, it can be amortized in one year if it meets IRS Section 179 guidelines
  • If you lease, since you do not own the equipment, any salvage value reverts to the lessor at the end of the lease period (although the lease may provide for a purchase option). - Interest rates “implicit in the lease” are usually higher than those charged by banks
  • If you don’t closely track dates specified in some leases, there is a risk of incurring significant additional charges. For example, failure to exercise a purchase option by the date specified can result in costly additional monthly payments.

Leased equipment cannot be used as collateral.

Leased equipment usually cannot be re-engineered, rebuilt, or altered to meet the particular production needs of the lessee. It must be kept "standard".

Kinds of Leases

Accounting standards classify leases as either “operating” or “capital” leases.

A capital lease results in an asset and a liability being shown on the lessee’s balance sheet, similar to how an asset purchased with a loan would be shown. The accounting and tax rules contain separate specific criteria to determine whether the lease is to be capitalized. Among others, these include leases where ownership is transferred to the lessee at the end of the lease or a purchase option is included.

Accounting/tax advisors can assist you in applying these rules. All leases which are not “capital” leases are “operating” leases.

Lease payments under operating leases are deducted in the year paid. Leases that are “capital” for tax purposes require that the assets be amortized and a portion of the payments used to reduce principal, similar to how a loan would be treated.

Other Lease Terminology

Net Leases

  • Lessee responsible for maintenance, taxes, and insurance.

Gross Leases

  • Lessor responsible for maintenance, taxes, and insurance.

Making the Lease/Buy Decision

The attached worksheet can be used to catalog information to help make a decision.

Using a Net Present Value Analysis approach is a good way to compare alternatives on a financial basis. This method can be made using computer spreadsheet software or a financial calculator. The same analysis technique may be used if you are considering purchasing equipment with internally generated or accumulated cash reserves of the company.

As noted above, a lease which contains an option permitting the lessee to buy the property may be considered as a “capital” lease so that none of the payment is deductible as rent.

The Net Present Value analysis can be used to determine the interest rate “implicit in the lease”, which can then be compared to rates available through other lenders. To determine the implicit interest rate, you will need to determine (or estimate) the following:

  • Cost of items to be leased
  • Residual value of the items at the end of the lease term (try to have the lessor provide this information)

If you use a financial calculator, input the following:

  • Present Value = Current cost of the items to be leased
  • Future Value = Residual value of the items at the end of the lease term
  • Payment = Monthly lease payment
  • Number = Number of months in the lease term
  • Interest = Solve for this. Multiply by twelve to get the annual rate of interest “implicit in the lease”.

LEASING - BUSINESS LOCATION

Before you sign a lease for your business facilities, be sure your business has a solid business plan in place. Consult an attorney for approved wording of the lease agreement.

When considering a property lease, determine:

  1. Are you required to carry insurance on your part of the building?
  2. Does the landlord have liability insurance?
  3. Do you have the right to sublet?
  4. Are there provisions for expansion?
  5. What restrictions are there on the use of the property?
  6. Is there plenty of parking available? (Check the parking lot on a busy day.)
  7. Is the rent high or low in relation to the area and facilities provided?
  8. What provisions are there for renewal or canceling of lease?
  9. How much must be spent on renovating, carpet, shelving, counters, decorating? Will the landlord pay for some of this through a build out or refurbishing allowance?
  10. Will building codes permit your plans for renovation?
  11. Do zoning laws permit your type of business?
  12. Will a building permit be required when a structure is changed?
  13. Who furnishes heat, light, water and repairs inside and out?
  14. Are there mutual waivers of subrogation (see Note below for sample wording)?

It’s advisable to have an attorney, and perhaps your insurance, agent review the lease prior to signing it. Check City, County and State offices to learn whether there are plans to build a new highway or relocation of existing ones that might affect traffic flow for the area.

Note: Following is sample wording for waiver of subrogation: Landlord and Tenant each hereby waives any and all rights of recovery, claim, action or cause of action against the other for any loss or damage that may occur to the premises or any improvements thereto, or any personal property of Landlord or Tenant, arising from any cause that (a) would be insured against under the terms of any property insurance required to be carried hereunder; or (b) is insured against under the terms of any property insurance actually carried, regardless of whether the same is required hereunder. The foregoing waiver shall apply regardless of the cause or origin of such claim … The forgoing waiver shall not apply if it would have the effect, but only to the extent of such effect, of invalidating any insurance coverage of Landlord or Tenant.

Leasing vs. Purchasing: Equipment Work Sheet

Answer the following questions to help determine whether it is better to lease or purchase equipment for your business in terms of:

Cost                               Cash Availability

 Tax Benefits               Obsolescence

Cost                                                                                              Lease                   Purchase

When is the required down payment for the lease or loan?

What is the length of the lease or loan?

What is the monthly payment for the lease or loan?

Are there balloon payments required for the lease or loan?

What is the amount of the balloon payment?

What is the interest rate?

What is the total cost of the lease or loan (including maintenance and warranty) over its lifetime?

Cash Availability                                                                         Lease                   Purchase

Is there sufficient cash flow to handle the monthly lease or loan payments? (Answer yes or no)

Are maintenance costs included in the lease or loan? (Yes or No)

What are the maintenance costs associated with the item?

What insurance costs are included in the lease or loan, if any?

What are the estimated insurance costs associated with the item?

If business is seasonal, does the lease or the loan better fit the seasonal cash flow profile?

Tax Benefits

Can the item be depreciated for tax purposes in a lease or loan?

What is the depreciable life of the item?

What is the estimated depreciable expense of the item over its depreciable life?

What is the amount of other tax benefits associated with this item?

Obsolescence

What is the operable lifetime of the item?

What is the total annual cost of the item spread over its lifetime?

What is the technological / useful lifetime of the item?

Will the item need to be replaced due to technological advancement?

What is the annual cost of the item spread over its useful lifetime?

Source: Entrepreneur Media, Inc. ©1993, Revised 9/2007

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Key Topics

Leasing Versus Buying Equipment -  SCORE 4.53