What Is A Tax Lease? The Pros & Cons Of True Tax Leases In 2023

If you’ve been researching equipment financing, you’ve probably noticed by now that there are tons of different types of leases. One term you may have come across is “tax lease.” Since leasing equipment can have an effect on your taxes, knowing exactly what a tax lease is and how it differs from other types of leases is important for your accounting practices.

Below, we’ll dive into tax leases and when they’re advantageous.

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 of the property for tax purposes. With a tax lease, the lessor assumes the costs and benefits of ownership, including depreciation and tax credits. Meanwhile, the lessee can claim their monthly lease payments as a business expense for tax purposes.

These types of financial arrangements are sometimes called true leases or true tax leases because they more closely resemble traditional leases.

Are Tax Leases The Same Thing As Operating Leases?

Until fairly recently, all operating leases were effectively tax leases, but as of December 2019, that is no longer the case. Since then, tax leases refer specifically to operating leases in which the lessee retains ownership of the equipment for tax purposes.

When Is An Operating Lease Not A Tax Lease?

Operating leases that last longer than one year require the lessor–the business taking out the lease–to account for the equipment on their own balance sheet. Because of this, operating leases that last longer than a year are not tax leases.

In an operating lease, the lessor is essentially renting the equipment to the lessee for the length of the term. At the end of the term, lessees are generally given the option to buy the equipment outright at fair market value. This is less likely to happen with tax leases since they have to adhere to strict time constraints, during which time the lessee is unlikely to have built up much equity.

Tax Leases VS Capital Leases

Capital leases are not and have never been tax leases. Unlike operating leases, capital leases really have only one function, and that’s to finance equipment that the lessee will go on to own. In a capital lease, ownership of the equipment is transferred to the lessee at the beginning of the lease.

In this regard, capital leases function more like loans than true leases, despite still having the trappings of leases, like residuals. Of course, these residuals are often as low as $1, which makes them little more than a formality. In this regard, they serve as an alternative to equipment financing.

Why Did The Rules Governing Tax Leases Change?

The short answer is that enough companies were gaming the system to keep assets off their books that investors started to lobby the Financial Accounting Standards Board, which handles leasing standards, to update its tax lease definition.

Essentially the problem was that around 85% of leasing commitments were going unreported prior to 2019. Previously, only capital leases were required to be recognized on the lessee’s balance sheet.

The Pros & Cons Of Tax Leases

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. For better or worse, the new tax lease definition greatly narrows the conditions under which businesses can effectively do that.

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 the best-case scenario, you could write your entire monthly lease payment off your taxes if you got a tax lease. To get the most bang for your buck (and to make sure you’re crossing all your T’s), 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 quickly or becomes obsolete in a short period of time. On the other hand, if you think you want to own the equipment, a capital lease may be a better option.

Leasing sounding too complicated? Check out our list of best small business loans.

FAQs: Tax Lease Definition