A capital lease is a fixed-term agreement, similar to a loan, where the lessee, the person taking out the lease, gets all rights of ownership of an asset, while the lessor, the person giving the lease, finances the leased asset. When this occurs, the lessee records the asset as property on the general accounting ledger. The lessee also pays all other costs associated with the asset such as insurance, maintenance, and taxes. For a lease to qualify as a capital lease, it must meet any of four criteria. Ownership of the asset must be transferred to the lessee by the end of the lease period. The lessee has the option to buy the asset from the lessor for below market prices at the end of the lease. The lease is not allowed to be cancelled, and the term of the lease is at least 75% as long as the useful life of the asset. The fair value of the asset is no less than 90% of the total present value of the lease payments over the term of the lease. Capital leases are different than operating leases. With capital leases, the asset is recorded on the balance sheet, an offsetting capital liability account is created, and charges to interest expense are recorded. With operating leases, each lease payment is only recorded as an operating expense and the asset remains off the balance sheet. For businesses, the difference between lease types is very important for taxes. Differences in tax amounts owed are determined by the life of the asset, the term of the lease, operating expenses, the depreciation schedule of the asset, and the interest expense. It is probably best to consult with a qualified tax accountant before choosing which lease type is best for your business.
Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.