Types of Leases

In a closed-end lease, the residual is set in advance and is guaranteed by the lessor.  At the end of the lease, the lessee has the right to simply return the vehicle to the lessor and “walk-away.”

The majority of consumer leases are closed-end leases.  Prior to signing a closed-end lease, the lessor estimates the value of the vehicle at the end of the lease-term, and sets the residual value.  The lessee can either turn-in the vehicle at the end of the lease, or purchase the vehicle for the residual amount.

If the actual value of the vehicle at the end of the lease period is less than the residual, the consumer just turns in the keys and the lessor eats the loss on the vehicle. If the value of the vehicle at the end of the lease is greater than the residual, then you can still purchase the vehicle for the residual amount.  You can then either keep the vehicle or sell it and keep the profit.  Being able to participate in any upside, while being protected from any downside is a major advantage of leasing.

In the open-end lease, the lessee, not the lessor takes all of the financial risks at the end of the lease.  At the end of the lease, the lessee can either purchase the vehicle for the amount of the residual, or can return the vehicle and pay any difference between the actual value of the vehicle and the residual.

The majority of open-end leases are commercial leases.  Annual mileage on a business lease is often-times greater than the mileage on personal automobiles, and the wear-and-tear can be significantly higher.  Thus, the actual value at the end of the lease period is harder to estimate, and the lessor is unwillingly to underwrite this risk.

Open-end leases typically have a lower residual than closed-end leases, trading off higher payments for less risk of a significant loss at the end of the lease-term.  Businesses use open-end leases to gain the financial and tax advantages of leasing.  In most cases, open-end leases are not appropriate for consumers.

A true lease is a lease that for federal income tax purposes allows the lessor to claim the tax benefit on lease equipment because the lessor has assumed the risks of ownership

To help ensure that your agreement is considered a true lease, consider the following:

1. The term of the lease shouldn’t be longer than the vehicle’s economic life.
2. Your lease payments can only amortize the value of the vehicle that is actually used, not necessarily its total value. The leasing company needs to demonstrate an appropriate level of risk for the vehicle from the beginning to the end of the lease.
3. If you decide to buy the vehicle at the end of the lease, you can’t pay less than fair market value.
4. The leasing company must expect a financial return from the lease beyond the inherent tax benefits of ownership.
5. You may not loan the leasing company the funds or guarantee the debt used to acquire the leased vehicle.
6. You can’t furnish any part of the cost of the leased vehicle, such as trade-ins or down payments.

Leveraged true leases generally involve three parties: a lessor, a lessee, and a lender to the lessor. The lender provides the lessor with credit, which the lessor then uses to finance the lease. The lessee then makes the payments on the lease, which the lessor uses to repay the loan to the bank.

In general, IRS Revenue Procedure 2001-28 provides that, for advance ruling purposes only, the IRS will consider the lessor in a leveraged lease transaction to be the owner of the property and the transaction to be a valid lease if all of the factors in the revenue procedure are met, including the following:

1. The lessor must maintain unconditional “at risk” equity investment in the vehicle (at least 20 percent of its cost) during the entire lease term.
2. The lessee may not have a contractual right to buy the vehicle from the lessor at less than fair market value when the right is exercised.
3. The lessee may not invest in the vehicle, except as provided by Revenue Procedure 2001-28.
4. The lessee may not lend any money to the lessor to buy the vehicle or guarantee the loan used by the lessor to buy the vehicle.
5. The lessor must show it expects to receive a profit apart from the tax deductions, allowances, credits, and other tax attributes.

A TRAC Lease is a type of open-end lease with a terminal rental adjustment clause (TRAC). TRAC leases are limited to motor vehicles and trailers leased to businesses and used at least 50 percent of the time for business purposes. TRAC leases were created by in 1982 by the Tax Equity and Fiscal Responsibility Act (TEFRA). A TRAC lease must meet all of the requirements for a true lease, except for the TRAC provisions. TRAC leases are unique in that federal tax rules permit a rental adjustment (cash rebate) back to the lessee at lease termination and can still be treated as operating leases.

At the beginning of the lease, a residual amount is chosen that will be used to determine the monthly payments. A higher residual results in lower monthly payments, and vice versa. At the end of the lease, the lessee has four options:

1. Purchase the vehicle for the residual amount.
2. Trade in for a replacement vehicle. Any positive or negative rent adjustment is applied to the new vehicle.
3. Extend the lease by financing all, or part, of the residual amount.
4. Turn in the vehicle and be eligible for a positive or negative rent adjustments.

The Financial Accounting Standards Board (FASB), under FASB 13 first issued in 1976, created guidelines for whether a lease constitutes a capital lease or an operating lease from a lessee’s and a lessors accounting perspective. This determination is different from whether or not a lease is a true lease for federal tex purposes.

From the lessee’s perspective only, if a lease meets or satisfies any of the following four criteria, the lessee must treat the lease as a capital lease and record the equipment on its financial statements as an asset and its payment obligations as a liability. If the lease does not meet or satisfy any of these accounting tests, the lessee may qualify its transaction as an operating lease.

The basic criteria for a capital lease appear in paragraph 7 of FASB 13. A lease constitutes a capital lease if the lease meets any one of these four criteria:

1. Automatically transfer ownership of the leased property to the lessee at the end of the lease term.
2. Contains an option that allows the lessee to purchase the leased property at a bargain price.
3. Has a term that equals or exceeds 75 percent of the estimated economics life of the leased property.
4. Requires rental or other minimum lease payments that, on a present value basis, equal or exceed 90 percent of the fair value of the leased property.

From the lessors perspective, if at inception a lease meets any of the four criteria, and in addition meets both of the following criteria, it will be classified as a capital lease. Otherwise, it will be classified as an operating lease.

1. Collectibility of the minimum lease payments is reasonably predictable.
2. No important uncertainties surround the amount of reimbursable costs yet to be incurred by the lessor under the lease.

In general, any lease that does not meet any of the criteria for a capital lease is considered an operating lease. When a lease is classified as an operating lease, the lease expenses are treated as operating expenses and the operating lease does not show up on the balance sheet of the firm. In almost all cases, a closed-end lease will be an operating lease.

A prepaid, or one-pay, lease is a lease where the lessee pays the entire lease obligation at the beginning of the lease. There are two types of one-pay leases:

1. Prepayment of all lease payments — Under this scenario, the lessee makes a single payment for the depreciation on the vehicle, use tax on the depreciation, any leasing fees, and interest on the residual.
2. Prepayment of all lease payments plus a deposit equal to the residual — Under this scenario, the lessee makes a single payment for the depreciation on the vehicle, use tax on the depreciation, any leasing fees, and a refundable deposit equal to the residual. At the end of the lease, the lessee can either turn in the vehicle or purchase it for the residual by agreeing to apply the deposit to the purchase.

A one-pay lease in appropriate for someone with available cash who doesn’t want monthly payments. The first option, prepayment of all lease payments, will reduce interest charges by charging interest only on the residual, whereas the second option eliminates interest altogether.

Individuals who typically pay cash for a business-use vehicle that is subject to the IRS’s luxury auto depreciation limitations and who trades in vehicles every three or four years will benefit significantly from a one-pay lease with a deposit equal to the residual.

A manufacturer’s lease is a lease where the vehicle’s manufacturer, rather than a bank, leasing company, or other third party, provides the financing for the lease. In many cases, the manufacturer will subvent (subsidize) its leases through artificially low interest rates or inflated residuals. As a result, the lessee can often reap thousands in savings over a traditional lease. One thing to look for in manufacturer’s leases is the mileage limits and mileage penalties. Many manufacturer’s leases with low payments have yearly allowances on only 10,000 or 12,000 miles and mileage penalties of 25 cents or more per mile. If you drive significantly more miles than this, be careful before signing one of these leases.

In most cases, lessees are looking for the lowers payment possible by setting the residual at the highest possible amount. However. there are several situations where it may make sense to lower the residual and make the monthly payments higher.

1. Purchase excess miles in advance — Many lessees drive more miles annually than are allowed with a standard lease. At the end of the lease, there may be significant mileage charges. One way to avoid this is to build the extra miles into the lease by lowering the residual and increasing the monthly payment. This ensures that there will not be any surprises at the end of the lease and spreads out the true cost of leasing the vehicle over the duration of the lease. Some lessors impose a lower mileage charge if you prepay the extra miles rather than paying the mileage penalty at the end. Make sure that you are going to be able to use these extra miles before you pay for them up front. If you do not use them, the lessor will not refund your money.
2. Increase tax write-off and lower buyout — A lessee may also reduce the residual and increase the monthly payment in order to get a larger tax write-off over the life of the lease. This approach is often used when the lessee is going to purchase the vehicle at the end of the lease and wants a lower buyout.
3. Make lease payment equal to loan payment — As mentioned several times, as a result of the IRS’s luxury auto depreciation limitations, there is a major tax advantage to leasing certain vehicles. Many people like to lease because the lease payments are lower than the corresponding loan payments would be for purchasing the same vehicle. However, the lease payment doesn’t have to be lower. One strategy we sometimes use is to reduce the residual to make the lease payment equal to the load payment. When this is done, from a financial point of view, the lessee is matching the payment stream from purchasing the vehicle. However, they are then able to take advantage of the higher tax write-offs from leasing the vehicle. As a bonus, when this is done, there is almost always equity in the vehicle at the end of the lease.

Setting the residual at one dollar results in the largest possible tax write-off during the life of the lease and is the most aggressive option possible. The legality of this was established in the U.S. Tax Court ruling in Harry E. Peaden, Jr. and Cindy D Peaden, Petitioners v. Commissioner of Internal Revenue, Respondent. Docket No. 14837-97, filed August 9, 1999.