Loan or Lease: What’s the Smartest Way to Finance New Asset Purchases?
If your company needs to expand its facilities or update equipment, you may be weighing the pros and cons of financing vs. leasing. Here’s some guidance to help you make an informed decision.
Few companies have enough cash on hand to purchase fixed assets — such as warehouses, office space, furniture and machinery — outright. Instead, the buyer may apply for a bank loan to acquire hard assets.
The loan term is usually tied to the item’s useful life (say, 30 years for a plant mortgage and five years for an equipment loan). The loan’s interest rate may be fixed or vary based on a market index. And most loans require a down payment of at least 10% of the asset’s price and personal guarantees from the company’s owners.
Borrowers can deduct interest expense and depreciation on their income tax returns. You can also elect to accelerate depreciation deductions under Section 179 and the bonus depreciation program. (These deductions could be impacted by tax reform legislation, however.) At the end of the loan term, the company owns the asset.
Alternatively, a lease is a contract between a company (the lessee) and a landlord or financing company (the lessor). The approval process for leases is generally quicker and easier than for bank loans.
A lease typically commits the lessee to make monthly payments over a period of time for the use of the equipment. Lease payments include imputed interest charges, which are typically higher than the interest rates for traditional bank loans. A lease also may include an option for the company to buy the equipment, for some stated price, at the end of the lease.
Lease terms can be flexible. Some leases require an initial down payment on the lease to help reduce monthly costs. Sometimes, the lessor covers all maintenance and insurance costs; other leases call for the lessee to pay these expenses over the lease term.
Although lessees lose out on interest and depreciation deductions, they’re allowed to deduct monthly lease payments for tax purposes. Additionally, during the lease term, a lessee may be allowed to upgrade to a new piece of equipment if technology improves. Or, if the business unexpectedly loses a major account, the lessee may be able to cancel the lease or downgrade to a smaller piece of equipment.
New Reporting Requirements
Current accounting rules require lessees to report capital (or finance) leases, but not operating leases, on their balance sheets. Capital leases transfer ownership of the underlying asset to the lessee by the end of the lease term. Leases that don’t meet the criteria established for capital leases are classified as operating leases.
Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), requires companies to report all leases with terms of at least 12 months on their balance sheets. The new guidance takes effect in fiscal years starting after December 15, 2018, for public companies, and for fiscal years beginning after December 15, 2019, for private ones.
The updated standard is expected to make lessees appear more leveraged than in previous years — which may cause loan covenant violations and hamper access to capital. So, it’s important to consider how the financial reporting changes will be perceived by stakeholders.
Manufacturers need to consider various tax, financial and practical issues before deciding whether to buy or lease fixed assets. Contact a tax advisor to help you understand the pros and cons of leasing.