Do you need equipment to run your business? If so, you might consider equipment leasing as a way to finance your equipment.
The act of leasing has been around for thousands of years. But the popularity of equipment leasing skyrocketed over the last 50 years.
Despite the rise in popularity, many business owners struggle with leasing versus buying equipment. But leasing offers plenty of advantages over paying cash or traditional bank financing.
Here’s our guide to understanding your equipment lease.
What Is An Equipment Lease?
You might think of leasing as something you do when you need space. For example, you rent a warehouse for your manufacturing business. The owner requires you to sign a lease that allows you to use the space.
You don’t own the building, but you make monthly payments to the owner for use of the building. Equipment leasing works in the same way.
The lessor owns a piece of equipment. You, as the lessee, sign a lease allowing you to use the equipment. What happens at the end of the lease depends on the terms of your lease agreement.
In most cases, you return the equipment to the owner or buy the equipment for an agreed upon price. There are many types of equipment leases and each type has its pros and cons. What works for your business might not work for another business.
Why You Should Consider Leasing
When deciding whether to lease, always consult your accountant. The primary difference between a lease and a loan is how it’s accounted for on your company balance sheet.
Here are a few of the main benefits of leasing.
Taxes
Leasing offers tax benefits. There are leases that work like loans, called capital leases. In this case, the equipment and lease obligation are recorded on your balance sheet.
Or opt for an operating lease where you don’t carry the lease on your balance sheet. Instead, you deduct the entire payment from your net income.
And you can take advantage of Section 179 benefits by writing off the entire cost of the lease on your taxes. Your accountant knows if this applies to you.
Flexibility
Leasing gives you options for what you do with the equipment when your lease is up. If your business requires regular equipment upgrades, then this flexibility is an advantage.
An example is a business that relies on computer software. When your software lease is up, you can upgrade to a newer version more easily than with a traditional loan.
Collateral
In almost every lease, the collateral securing the agreement is the equipment itself. Banks won’t often do this type of loan. They need a business to pledge all its assets to finance equipment.
Favorable Payment Terms
One of the number one reasons people choose to lease is because they can get better payment terms with a lease. Many lease companies need very little money down.
They also offer flexibility in how you structure the lease. With a larger buyout at the end of the lease, you’ll lower your monthly payments. For a business that needs equipment but is short on working capital, this is a win-win situation.
Easy Application Process and Paperwork
Because leases are usually a smaller dollar amount, you don’t have to round up as much paperwork to get one. This is in comparison to a bank which requires several years of financials to approve a loan.
Most leasing companies approve you for a lease within an hour of application, as long as your credit is good. And lease paperwork is usually simpler than loan paperwork.
Types of Leases
As we mentioned earlier, there are two common types of leases. A capital lease is more like a traditional loan. It allows your accountant to keep the equipment and the debt on your balance sheet.
When the equipment and debt stay on your balance sheet, you take advantage of depreciation expense. But it also means you’ll show more debt on your balance sheet.
An operating lease is more like a rental agreement. It is off-balance sheet financing. This allows you to expense the entire lease payment instead of depreciating it.
There are three major types of leases that fall into the categories of capital and operating leases. What you choose depends on how your accountant wants to record the lease.
$1 Purchase Option
With a $1 purchase option (PO), you agree to lease the equipment for a certain amount of time. This depends on the equipment, but usually five years or less. Then you buy the equipment for $1 at the end of the lease.
This type of lease is essentially rent-to-own because you wouldn’t ever return a piece of equipment in this situation. $1 PO leases are treated as capital leases on your balance sheet.
Construction equipment is often leased on $1 PO. It’s a long-term investment and still has value at the end of the lease.
10% Purchase Option
A 10% PO means you buy the equipment for 10% of the purchase price at the end of the lease. For example, let’s say you buy the equipment for $10,000. Then you’ll pay $1,000 to buy the equipment at the end.
This type of lease is also considered a capital lease, like a $1 PO. This is a good option if you want your monthly lease payments lower than they would be with a $1 PO.
Fair Market Value Lease
Fair market value (FMV) is a true operating lease. Meaning it’s off-balance sheet and you’re able to deduct the monthly payments as rent.
This type of lease is set up for a certain term, say 5 years, and at the end of the term, you have three options.
- Buy the equipment at FMV as determined by the leasing company.
- Renew the lease for another term and continue to use the equipment as a lessee.
- Return the equipment to the lessor.
FMV leases are good for equipment that loses value. Or for technological equipment that becomes obsolete after a few years. That way you have the option to return the equipment and upgrade when the lease is up.
Is An Equipment Lease Right For Your Business?
There are two main ways to account for equipment leases: on-balance sheet (capital lease) or off-balance sheet (operating lease).
Within these categories, you have several options for the type of lease you set up. A $1 PO is more like a lease-to-own option. An FMV lease is an option where you are likely to give the equipment back after the lease is up.
Or choose a 10% PO lease to lower your monthly payments but have the option to buy the equipment at the end. No matter what you choose, you’ll find that leasing has benefits.
Talk to your tax preparer today to find out if an equipment lease is right for your business. And check out our blog for more helpful articles about equipment financing options.