The Difference Between Capital and Operating Leases

By Anjelica Baker - May 25, 2021

Since used car leasing was invented over 20 years ago, it has been proven to generate more profit than a buy-here-pay-here. This isn’t surprising considering the tax implications that are clearly in favor of leasing. With buy-here-pay-here, the taxes on the entire contract are paid at the end of the year but with used car leasing the taxes are only paid as payments from the lessee are received. There are also federal regulations in place that prevent leased cars from being included in bankruptcies. A lease is somewhere between renting a vehicle and buying a vehicle. A lease is a way to drive a car for a specified period of time and only pay for the part of the car you use.  If the lessee decides to pay off the balance on a lease and not purchase the vehicle, they can. If the lessee decides to end the lease before it lease term end, they can. If the lessee pays off the full obligation plus the residual, they OWN the vehicle. Simple!

There are two types of leases. This difference applies to the way that the lease is recorded. The difference between a Capital and Operating lease is that you can ‘Capitalize’ by recording a receivable on your books. This type of lease will transfer substantially all benefits and risks of ownership.

In order for a lease to be recorded as capital, it must be non-cancelable and at least one of the following criteria must apply:

    1. Transfer of ownership to the lessee
    2. Contains a bargain purchase option
    3. Lease term is equal to or greater than 75 % of the estimated economic life of the lease property
    4. The present value of the minimum lease payments equals or exceeds 90 % of the fair value of the leased property.

In other words, if you are transferring the title of a vehicle, setting a residual so low that you are almost guaranteeing a purchase at the end of the lease term, leasing a vehicle for more than half of its expected life or leasing a vehicle more than half of its value then more than likely you are guaranteeing a purchase at the end of the lease and the lease should be recorded as a sale. This means that depreciation expense will not be recorded on since ownership of the asset has transferred to the lessee and there would be no lease inventory for the lessor.

If the lease does not meet any of the four criteria aforementioned, the lease would be recorded as an Operating lease.  With an Operating lease there is what we call “off-balance sheet financing” which is what makes this type of lease more attractive from a financial stand-point. Revenues are earned as payments are received, there is no receivable on the books, so it’s as if a cash sale is taking place each time a payment is received.

Overall, leasing is favorable as far as profit, and building a rapport with the lessee. The lessee has the option to return the vehicle without purchasing it, which allows the lessor to lease the vehicle to a new lessee and place the returning lessee in a new vehicle. Sales taxes are paid as payments are received and revenue is earned as payments are received.  It’s that simple!

To learn more about leases, please call your customer support representative at 1-800-526-5832.

Subscribe to Deal Pack Blog