Capital Lease vs. Operating Lease—What’s the Difference?
When comparing the capital lease vs. operating lease the differences have to do mainly with the accounting method, the tax treatment and the ownership of the equipment. Here are the typical differences between the two types of leases.
The capital-type is more like a loan. The equipment you are leasing is treated as an asset and appears on your balance sheet. The loan payments are treated as liabilities.
The operating-type is treated similarly to the rent that you pay on your building every month. Your monthly payments are treated as operational expenses in your profit and loss statement. The equipment is not considered an asset.
Equipment you acquire through a capital-type lease is treated as an asset by the IRS. You may be allowed to claim depreciation and deduct interest as an expense. You may have capital gains or losses related to the equipment.
With the operating-type, the monthly payments are treated simply as expenses of doing business. They basically lower your business income, which could reduce the taxes you owe.
Consider asking your accountant to compare the tax treatment of capital versus operating leases to find out which would be more advantageous for your business at this time.
With the capital-type, ownership is transferred to your business at the end of the lease term. You are responsible for maintenance, insurance and other expenses related to the equipment. If the equipment becomes unserviceable for any reason, you may still be responsible for the monthly payments.
With the operating-type, ownership is retained by the leasing company at the end of the term, although you may have the option to take ownership of the equipment, if you choose to do so.
In terms of maintenance and service of the equipment, there may be no clear winner in a comparison of the capital lease vs. operating lease option. Some companies do offer to include a service agreement in their financing program.
In general, some leasing companies are more flexible than others and there can be some overlap between the two types in terms of ownership and servicing the equipment. Direct lenders tend to be the most flexible in this regard.
The issue of being the owner of obsolete equipment is one to consider when you are comparing capital versus operating leases. Since you will retain ownership of the equipment at the end of the term of the capital-type lease, you could be the owner of obsolete equipment that is difficult to get rid of but can no longer be used in your field.
This has become more of a problem for business owners in recent years because technology is changing so rapidly. The owner is responsible not only for acquiring new equipment with the latest technology, but also with disposing of the obsolete equipment. There are often costs associated with equipment disposal.
Leases vary in their wording. What you have read about here is true in most cases. But always read the fine print and/or ask your accountant to look over the paperwork before you sign.
When choosing between the capital lease vs. operating lease option, much has to do with the type of business you are in and the type of the equipment you need. In many cases, the operating-type is the best choice.