What Is A Tax Lease? The Pros & Cons Of True Tax Leases

A tax lease is one type of equipment lease. Since leasing equipment can affect your taxes, it’s important to know what a tax lease is, who it’s best for, and how it differs from other types of equipment leases.

Below, we’ll dive into tax leases and help you determine if it’s the right fit for your business. If you’re looking for equipment financing, start your search with our picks for the best equipment financing companies.

What Is A Tax Lease?

A tax lease is a form of operating lease in which the lessor — the equipment leasing company — is considered the owner for tax purposes. Tax leases are also known as true leases or true tax leases.

With a tax lease, the lessor assumes the costs and benefits of ownership, including depreciation and tax credits. The lessee can typically deduct lease payments as a business expense.

Tax leases can vary in length but are structured so the lessor retains ownership for tax purposes.

The Pros & Cons Of Tax Leases

A tax lease isn’t the right type of equipment financing for every business. To determine if a tax lease fits your needs, review the pros and cons before signing a lease.

Are Tax Leases The Same Thing As Operating Leases?

Tax leases are generally a type of operating lease, but the terms aren’t interchangeable.

A tax lease (or true lease) is defined by how it’s treated for tax purposes. In this structure, the lessor (the leasing company) retains ownership of the equipment and claims benefits like depreciation. The lessee simply makes payments and typically deducts those payments as a business expense.

An operating lease, on the other hand, is an accounting classification. Since updated accounting standards took effect in 2019, most operating leases must be recorded on a company’s balance sheet. However, this change affects financial reporting — not how leases are treated for tax purposes.

In other words, a lease can be considered an operating lease for accounting purposes and still qualify as a tax lease.

When Is An Operating Lease Not A Tax Lease?

Not all operating leases qualify as tax leases.

A lease is considered a tax lease only if it meets specific IRS guidelines that determine who holds the benefits and risks of ownership. If a lease is structured so that the lessee effectively owns the equipment — even if it’s labeled as an operating lease — it may not qualify as a tax lease.

The key distinction comes down to ownership and economic substance, not the length of the lease or how it’s reported on financial statements.

Tax Leases VS Capital Leases

Capital leases (also known as finance leases) are not tax leases.

A capital lease is structured so the lessee effectively gains ownership of the equipment, either during or at the end of the lease term. Because of this, the lessee — not the lessor — typically claims depreciation and other tax benefits.

In practice, capital leases function more like loans than traditional leases. Many include a purchase option at the end of the term, sometimes for a nominal amount (such as $1), making ownership all but certain.

Why Did The Rules Governing Tax Leases Change?

Before 2019, a large portion of lease obligations were kept off balance sheets. At the time, only capital leases were required to be recognized on the lessee’s balance sheet.

However, companies were gaming the system to keep assets off their books. Investors began to lobby the Financial Accounting Standards Board to update lease accounting standards.

Is A Tax Lease The Best Way To Finance Your Equipment?

The ability to treat equipment as an operating expense has a lot of benefits, which is probably why the practice was so heavily abused in the past. As a result, updated accounting rules narrowed how leases are reported on financial statements.

Beyond those limitations, whether or not a tax lease is the best way to finance your equipment depends largely on the way you keep your books and write off your business expenses. In some cases, you may be able to deduct your full lease payment as a business expense. To maximize tax benefits, you’ll want to consult your accountant.

Since tax leases fall under the umbrella of operating leases, you’ll also want to consider the type of equipment you’re leasing. An operating lease is usually best for equipment that you aren’t certain you want to own, often because it depreciates or becomes obsolete quickly. On the other hand, if you think you want to own the equipment, a capital lease may be a better option.