A lot of clients, sole proprietors and corporate clients, ask me which is better, to lease or finance? There are so many variables at play here but I will focus on the main points.
Finance
Financing is easy and straightforward bookkeeping wise. There will be an asset and an offsetting loan or liability on your balance sheet. For tax purposes you can expense the interest on the loan and the depreciation of the vehicle or equipment. Depreciation is usual 30% on the declining balance.
Lease
Leasing gets a little more complicated because there are two types of leases: capital and operating.
Capital Lease
A capital lease is very similar to financing for bookkeeping and tax. There will be an asset and liability on the balance sheet and interest and depreciation are expensed.
Operating Lease
The full amount of the lease payments are expensed as they are paid. There is no asset or liability to record, and depreciation isn’t captured.
That’s great, but how can I tell the difference between a capital lease and an operating lease? Any one the following criteria must be met in order to qualify as a capital lease:
- Ownership transfers during or at end of the lease term. This usually happens with most leases.
- The purchase price option is lower than fair market value. For example, when purchasing a car, the purchase price option is usually higher than the value of the car at the end of the lease. You fell like you’ve paid a lot of money for this car and then dealership wants another $15-20K at the end. Most car leases are operating leases. Machinery and equipment leases, on the other hand, usually have a low purchase option and are therefore capital leases.
- The lease term covers a substantial portion of the life of the asset (usually over 75%). This could be true of cars or machinery and equipment.
- The present value of lease payments covers substantially all (90% or more) of the asset’s fair market value. This is usually true in the case of machinery and equipment, hence the low purchase option. The present value of car lease payments, however, do not usually cover 90% of the fair market value. This is why the purchase option or buy out price is high.
So let’s get down to the nitty gritty. When buying a car for company use, leasing will have even claimable expenses throughout the life of the lease, but a big chunk of cash required at the end of the lease for the buy out. Financing that same car will have higher claimable expenses at the beginning of the life of the vehicle (the depreciation expense).
Quite often lease payments are less than financing options and are therefore more attractive from a cash flow perspective. If cash flow isn’t an issue, personal choice also factors in to the equation. Quite often you can forgo the purchase option or buy out by leasing another vehicle. That could mean lease payments for a very long time and never really owing your vehicle, but a new care every 3-5 years.
Machinery and equipment claimable expenses will be about the same with financing or leasing because it will most likely be recorded as a capital lease. Financing and lease payments may be very similar. Check the terms of both to see which is more attractive for cash flow.
Whether you lease or finance, please be sure to keep a vehicle mileage log for all your business travel. If you have any further questions on leasing vs financing please contact me at pam@pamlittlecpa.com or 416-268-1605.
Pam Little is a Chartered Professional Accountant with over 25 years of experience. She helps individuals and small businesses with all their accounting needs. The information in this article is of a general nature only and your tax situation may differ from this. If you have specific questions please book a free consultation with Pam Little, CPA, at pam@pamlittlecpa.com or call 416-268-1605.