A lease refers to an arrangement by which you use an item that belongs to another party for a certain period of time and pay a fee for the privilege. A capital lease, also known as a finance lease, runs for most of the useful life of the asset and has various advantages and disadvantages.
For many purposes, a capital lease "has the qualities of a purchase," according to the Oklahoma Cooperative Extension Service. The lease term runs for at least 75 percent of the asset's life, so you get more use out of the asset compared to the actual owner. A capital lease also gives you the option to buy the leased asset at the end of the lease period, usually at a discount from the market price.
You can claim tax deductions on the cost of your capital lease. This works as a depreciation, with you claiming a deduction each year over the life of the leased asset. For example, assume the leased asset is worth $10,000 and you expect it to remain useful for five years. If you expect it to be worth $2,000 at the end of the useful life, you can claim $1,600 each year for five years (from ($10,000 - $2,000) / 5).
You have to record a capital lease arrangement in your financial statements. The present value of all future lease payments appears as debt, increasing the total amount of liability on your balance sheet. This may make your finances appear less attractive to prospective investors. In contrast, a regular operating lease does not require you to record the details in your financial statements. Some businesses avoid capital leases to minimize their liabilities as reported on the balance sheet.
With a capital lease, you have to take care of all repairs and maintenance of the leased asset as if it were owned by you. This may increase your expenses and reduce your profits. Additionally, if the leased asset deteriorates during the lease term, you will still have to take over its ownership. This means that you will suffer losses if the property declines in value -- for example, if it sustains damages or new technology has made it obsolete.
- Food and Agriculture Organization of the United Nations: Sources of Finance -- Leasing
- Oklahoma Cooperative Extension Service; Capital Leases; Damona Doye, et al.; May 2011
- New York University; Operating Versus Capital Leases; Aswath Damodaran
- Financial Accounting Standards Board. "Preparing for the Upcoming Leasing Standard: What a Lessee Needs to Know." Accessed Aug. 8, 2020.
- Accounting Codification Standards. "840-10-25-1." Accessed Aug. 8, 2020.
- Accounting Codification Standards. "840-10-25-43." Accessed Aug. 8, 2020.
- Internal Revenue Service. "Publication 535: Business Expenses," Page 11. Accessed Aug. 8, 2020.
Edriaan Koening began writing professionally in 2005, while studying toward her Bachelor of Arts in media and communications at the University of Melbourne. She has since written for several magazines and websites. Koening also holds a Master of Commerce in funds management and accounting from the University of New South Wales.