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Should You Lease Or Buy?

Got your eye on that sporty new car, even though it could be out of style in a couple of years? Many people choose to lease cars regardless of whether it is in their best financial interests. But what about business property, where all a business owner really wants is the most cost-effective solution?

The consumer often decides whether to lease or buy using qualitative factors. For example, prestige, convenience or safety may have more to do with the decision than price. Businesses are more likely to decide whether to lease or buy using a quantitative approach, choosing the course that will leave the company in the best financial position. By considering the payment terms, tax consequences and incremental rate of return that can be achieved, it is possible to determine the better move financially.

It is important to understand that by financing a purchase of property, the consumer or business owner is paying to own the property. Lease payments are made only to use the property. At the end of the lease term, the asset may be returned to the lessor (the owner of the property), or there may be an option to buy it.

When comparing the payment terms for financing and leasing, the financing payments generally will be higher. This is because lease payments cover only the depreciation of the asset during the lease term. For example, if a car’s current price is $50,000, and at the end of a five-year lease the car’s resale value is expected to be $20,000, the lessee is paying only for the $30,000 of depreciation. However, financing payments would cover the entire $50,000 value of the car.

While lease payments may be lower than financing payments, there is a second component: interest. Whether you’re paying for the asset’s full value or just its depreciation, your lender must also be compensated for the time value of money. Technically, lease payments do not include “interest,” because interest is defined as a charge for the direct use of money. The lessee’s use of money in a leasing arrangement is indirect: The lessor has tied up its money to acquire an asset that the lessor continues to own and that the lessee will merely use. The compensation for time value of money in a lease is called “money factor.” For the purposes of this article, “interest rate” and “money factor” mean the same thing.

Many consumers don’t understand that there is an implicit interest rate when they choose to lease. Online calculators at www.efunda.com/formulae/finance/lease_calculator.cfm can compute the interest rate or monthly payment for a lease. Lease payments generally will include a higher interest rate than what would be charged to finance. Because the asset is returned at the end of the lease term, the lessor takes on additional risk. For example, the asset may be worth less than expected at the end of the lease term, or it may be impossible to find a new lessee. The lessor is compensated for these risks through a higher interest rate.

Ownership has other advantages and disadvantages. Advantages include the possibility of appreciation or resale value of the asset. For business owners, another advantage is the ability to accelerate tax deductibility, discussed later in this article. Disadvantages include the responsibility to maintain the asset after the warranty expires, as well as the possibility of obsolescence. Obsolescence can be a major factor in the leasing/buying decision. For example, a consumer who never wants to drive a car that is more than a few years old may be better off leasing. Having to sell a car every few years can be quite a hassle, and the time spent negotiating may be better used.

The advantages of leasing include the ability to avoid maintenance and obsolescence. Many lease terms will expire at the same time as the warranties, so the lessee is not required to pay directly for maintenance or repairs. The main disadvantage of leasing is that the lessee can be locked into an endless cycle of lease payments that never results in ownership.

Statistical evidence shows that consumers choose to lease cars more often when interest rates are high and manufacturers are not offering substantial purchasing incentives. For example, according to www.bankrate.com, in 1999 leasing contracts comprised about 40 percent of manufacturers’ deals on new cars. Since interest rates have dropped and manufacturers have introduced more purchasing incentives, car leases are less popular. Recent data reflect that about 15 percent of new cars are leased.

While data on the percentage of business assets that are leased are not available, according to www.elease.com, more than 80 percent of U.S. businesses lease at least some of their equipment. Since business equipment can be complex and expensive, this is not too surprising. However, the percentage of overall business assets that is leased is much lower, because leasing minor items is not practical.

While it is possible to lease items such as software and furniture, many business owners choose to purchase these assets simply to avoid dealing with recurring payments. With the exception of home ownership, consumers generally cannot receive a federal tax benefit when they purchase or lease property for personal use. However, buying or leasing property can provide important tax benefits for business owners. Tax consequences can have a significant impact on a business owner’s decision regarding whether to lease or buy.

Taxation of lease payments for businesses usually is simple. Payments are generally 100 percent deductible. If an asset is used partially for personal use, only the business portion of the lease payments is deductible.

Special Tax Treatment For Vehicles

Lease taxation becomes tricky, however, when a business leases automobiles. If the fair market value of a leased car is more than a certain amount (the most recent threshold is $15,200 as of 2005), the business may be required to reduce its lease payment deduction by a specified amount, called the “inclusion amount.” The effect of the inclusion amount for automobiles is to bring the lease payment deduction in line with what the depreciation deduction would be had the business purchased the automobile instead. Inclusion amount also can be an issue for non-vehicle property if the leased property’s business use is less than 50 percent. Again, the inclusion amount for non-vehicle property will bring the deduction in line with the tax benefit the business would have received had the property been purchased.

The tax consequences of ownership can be more complex but much more rewarding for business owners. Instead of deducting payments, businesses deduct the asset’s value using depreciation expense over the useful life of the asset. The interest component of financing payments is deductible as it is paid.

Business owners may accelerate deductions as a result of purchasing an asset in two ways. The first is accelerated depreciation. The Internal Revenue Service allows the use of certain accelerated depreciation schedules for business assets. However, beware of accelerated depreciation if you expect to be subject to the alternative minimum tax (AMT). The AMT adds back any accelerated depreciation deductions so that no additional benefit is received.

The second way to accelerate deductions is the Section 179 expense deduction, which allows all or a portion of the cost of new qualified business assets to be daeducted immediately. This deduction is not available to all businesses, and may not result in a benefit. For example, the deduction cannot exceed business income, so businesses that are not profitable cannot benefit from Section 179. Large businesses generally cannot use the Section 179 deduction, because there is a phase-out of the deduction based on the amount of property purchased during the year. Also, the asset must be used at least 50 percent for business purposes. The maximum Section 179 deduction for 2005 is $105,000, and the maximum deduction for 2006 is $108,000.

Making The Most Economical Decision

The analysis of whether to lease or buy begins by comparing the cash inflows and outflows for each strategy. Outflows are the payments to own or lease the property. For businesses, inflows are the tax savings, received once a year when the business files its annual tax return. The property’s residual value, or resale value, should also be included in the analysis. Based on the inflows and outflows, you will probably find that although leasing ties up less of the business’s cash at inception, leasing is more costly in the long run than buying.

But there’s one final consideration that can turn the tables. Since a lease requires less up-front cash than a purchase, leasing may ultimately be beneficial if the business can invest its available cash at a high enough rate of return. This can be a major factor, depending on what rate of return can be achieved. For example, a business that is growing rapidly may choose to lease its assets even if leasing is a more costly way to acquire the assets. By leasing, the business owner will make lower payments and will have more cash to reinvest in the business. By facilitating reinvestment in a highgrowth business, leasing may end up being the most economical choice because of compounding returns.

A mature business with a low growth rate is likely to be better off purchasing assets. Depending on the incremental rate of return, sometimes the best strategy for a company will be to purchase assets outright with cash, instead of financing. This way, the company can avoid paying interest.

As for consumers, the incremental rate of return that can be achieved is determined by considering where the savings will go. Will the savings be reinvested into an aggressive investment portfolio with a high expected rate of return? In this case, leasing could be preferable. However, if the consumer has a low-risk portfolio with a low expected rate of return, or plans to spend the savings, purchasing is likely to be the better strategy.

Financing is usually a better financial decision for consumers because it results in ownership and comes with a lower interest rate. However, consumers should certainly consider qualitative factors as well. Those who are willing to forgo a certain amount of savings in return for the benefits they will receive from leasing (convenience, prestige, etc.) may find that leasing is for them after all.

One final note on leasing due to a high available rate of return: Taking on more leases implicitly means taking on a greater degree of leverage. By the logic mentioned above, a business or consumer with a very high expected rate of return would be better off leasing everything. But if the actual rate of return is less than expected, this could result in a major loss or even bankruptcy.

Analyzing cash flows and considering the incremental rate of return removes a lot of the guesswork from the leasing vs. buying decision. Other considerations such as degree of leverage may also play major roles in the decision-making process. Crunching the numbers shows that buying generally is cheaper than leasing over the long run, but a high available rate of return may make leasing the better strategy.