Tax and Accounting Aspects of Leases - Financial Management

Leasing assets involves a number of tax and accounting considerations,which are examined in this section.

Tax Status of True Leases

Annual lease payments are tax deductible for the lessee if one crucial criterion is met: The IRS must agree that a contract truly is a lease and not just an installment loan called a lease. Before embarking on a lease transaction, all involved parties should obtain an opinion from the IRS regarding the tax status of the proposed lease. The opinion of the IRS normally revolves primarily around the following general rules:

  • The remaining useful life of the equipment at the end of the lease term must be the
  • greater of 1 year or 20 percent of its originally estimated useful life.
  • Leases in excess of 30 years are not considered to be leases for tax purposes.
  • The lease payments must provide the lessor with a fair market rate return on the investment.
  • This profit potential must exist apart from the transaction’s tax benefits.
  • Renewal options must be reasonable, that is, the renewal rate must be closely related to the economic value of the asset for the renewal period.
  • If the lease agreement specifies a purchase option at the end of the lease period, the purchase price must be based on the asset’s fair market value at that time.
  • The schedule of lease payments should not be very high early in the lease and very low thereafter. Such a payment schedule suggests that the lease structure is being used merely to avoid taxes.
  • In the case of a leveraged lease, the lessor must provide a minimum of 20 percent equity.
  • Limited-use property (valuable only to the lessee) may not be leased.

If the IRS does not agree that a contract is truly a lease, taxes are applied as if the property had been sold to the lessee and pledged to the lessor as security for a loan. The reason for the IRS restrictions previously cited is that the IRS wants to prohibit lease transactions set up purely to speed up tax deductions. For example, a building would normally be depreciated over 39 years under MACRS depreciation rules.

It would be possible to set up a lease over a 3-year period that allowed the lessee to effectively write off the cost of the building for tax purposes over 3 years. This would increase tax deductions for the lessee at the expense of tax receipts to the U.S. Treasury. These IRS guidelines are designed to prevent this type of abuse.


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