Capital Lease Example
Let’s look at a specific example of what might constitute as a capital lease. Jim’s Construction Inc. decides to purchase a new backhoe, purchase price is $100,000, for the fleet. Jim is considering leasing as an option of financing but he isn’t sure what type of lease. Jim thinks about it for awhile and comes to the following conclusions about how he would like this to go. He thinks that his payback period (remember, this is the amount of time it will take to earn enough income from this equipment to pay the loan or lease in full) for this equipment is about 3 years, so he knows that he wants a term of at least 3 years. At the end of term, he would like to keep the equipment but he doesn’t want to have to worry about making a large payment to get it.
Capital Lease Breakdown
1. The lease term is greater than 75% of the asset’s estimated useful life
Jim has told us pretty much all we need to know to figure out what type of lease he should look for. We only need to find ONE of the criteria set forth to qualify this lease as a capital lease. Looking at the first of these criteria, “the lease term is greater than 75% of the assets estimated useful life”, we need two pieces of information to figure this out.
- How long is the term of the lease?
- How long is the estimated useful life of the equipment?
We have the first piece of information. Jim would prefer a lease term of 3 years. The second piece is a little more difficult to obtain and differs for each piece of equipment. The estimated useful life of a piece of equipment is a question best suited for your accountant. But let’s use common sense on this one, we know a backhoe is a heavy piece of machinery made from steel. Odds are a piece of equipment like this will last at least 5 years. So using a simple calculation:
Lease term / Estimated Useful Life of Equipment = %
Or 3 years / 5 years = 60%
We can see that this is not greater than 75% and thus, as of the first of the criteria, this is not yet considered a capital lease.
If Jim decided that he wanted a 4 year lease term then it would be easy to see that this would qualify as a capital lease.
4 years / 5 years = 80%
And because 80% is greater than 75%, this would qualify as a capital lease.
2. The lease contains a bargain purchase option to buy the equipment less than fair market value.
Jim also specified that he does not want to make a large payment at the end of the lease term to purchase the equipment. This triggers that Jim is looking for a capital lease. A bargain purchase option as defined by FASB is “a provision allowing the lessee, at his option, to purchase the leased property for a price which is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable that exercise of the option appears, at the inception of the lease, to be reasonably assured.”
What does that mean!? Basically, it is saying that at the end of the lease, when the option to purchase the equipment is available, if the lessee purchases the equipment for an amount “sufficiently” lower than fair market value, then it counts as a bargain purchase option. The key is “sufficiently lower”. This isn’t the time to cut it close. There is no exact rule of thumb for what sufficiently less is, but if Jim were to purchase the equipment for 10% of the purchase price and the fair market value is deemed to be 20%, then this should count as a capital lease in the eyes of the IRS.
If Jim decided to consider a fair market value lease, the fair market value of the equipment would be determined at the end of the 3rd year when the lease is up. At that time, Jim and the seller would have to come to an agreement on what the backhoe’s value is. Given his scenario of wanting a 3 year term on a piece of equipment that has a useful life of at least 5 years (probably more), it is likely that the backhoe would still hold some value because it still has at least two years of useful life left. If the fair market value of the equipment is 20% at the end of the 3rd year, then that is what Jim would have to pay to keep the equipment. Jim would have to pay $20,000, which equates to 20% of the purchase price. And because Jim indicated he does not want to pay that much at the end of the lease, Jim will be seeking a capital lease.
Two common bargain purchase options at the end of the lease that would qualify as less than fair market value are:
- One-Dollar ($1) Buyout
- Fixed Buyout of 10% or less
One-Dollar ($1) Buyout
A one-dollar buyout purchase agreement is just that, the lessee pays the lessor $1.00 at the end of the lease term in order to transfer ownership. Having a dollar buyout at the end of term makes the lease look exactly like a term loan of the same term. The payments will be exactly the same. The only difference really is the name, and the fact that you have to send a check to the lessor for $1.00 at the end of the term.
Each Leasing Company will handle the dollar buyout differently. Most will actually require you to write and send a check for one dollar. Some will not. My advice is to play it safe and send the check every time. This will ensure that the equipment is yours no matter what. The last thing you want is a lawsuit over equipment ownership because of $1.00.
Fixed Buyout
A fixed buyout is a predetermined amount of money that will need to be paid to the lessor by the lessee at the end of term. Common fixed amounts are 10%, 5%, or 3% of the total equipment value. In Jim’s case, if he decided that he wanted to pay a lower amount, like 3%, then he would end up paying 3% of the total equipment cost. So as Jim makes his last payment, he would have to write a check for an additional $3,000 just to be able to keep the equipment and transfer ownership.
As long as the fixed buyout is sufficiently less than what would be considered the fair market value of the equipment at the end of the term, then the lease would qualify as a capital lease. Having a fixed buyout greater than $1.00 will make your monthly payments smaller. The larger the fixed buyout, the lower the monthly payment. This is because you are deferring that chunk of the payments to the end of the lease term. This can be helpful with trying to manage your cash flow better.
3. Ownership of the asset is transferred to the lessee at the end of the lease term
As Jim already knows, he wants to keep this equipment at the end of the lease. He doesn’t want to have to negotiate at the end, he just wants to make his last payment and that’s it, the equipment is his. He can achieve this through a capital lease. The most common way to do this is by negotiating a “One- Dollar ($1) Buyout” at the end of term. This will satisfy the requirement to transfer ownership of the asset at the end of the lease term without really having to do anything, other than send that check for $1.
Once Jim makes his last payment and the asset is in his possession, the Uniform Commercial Code (UCC) filing will be released by the lender. A lender will file a UCC with your states office in order to perfect a security interest in the named collateral and establish priority in case you default or go bankrupt. Basically, a UCC filing is placed on most assets financed through a lender to protect the lender from not being able to repossess their equipment in case you decide to not pay them back. Remember, the equipment belongs to the lender until the very last payment is made. So yes, it is their equipment.
4. The present value of the minimum lease payments exceeds 90% of the total original cost of the equipment.
This is by far the trickiest of all of the requirements. If we are to look at this using Jim’s example we can put this more simply. Jim is buying a $100,000 piece of equipment. Let’s assume his interest rate is 6%, he wants a term of 5 years with a 3% fixed buyout at the end of term. His monthly payment using this example would be $1,890.28. His minimum lease payments would be the sum of all payments he is making minus costs such as residual value (which is his fixed buyout) and any other executory costs or penalties for failure to extend or renew the lease. So in order to calculate that we would need to take out the $3,000 fixed buyout he has at the end of the lease. The amount calculated is then discounted using the lessee’s incremental borrowing rate. However, if the lessee knows the implicit rate used by the lessor and the rate is less than the lessee’s rate, the lessee should use the lessor’s rate to discount the minimum lease payment.
