The Difference Between FMV and Capital Leases Explained

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One question we’re asked over and over again here at Point Blank is “What is the difference between a Fair Market Value Lease and a Capital Lease?”  Well, luckily Direct Capital is here to clear the air.

They’re kind of the step-siblings of the finance world – part of the same family, but it’s easy to see some dramatic differences.  For starters, a Capital Lease (sometimes called a Finance, Nominal, Buck-Out or Dollar-Buyout Lease) provides a fixed monthly payment during the life of lease.  The most distinguishing feature, however, is the option to purchase the equipment for a nominal price at the end of the term – sometimes for as little as a dollar.  The whole “Dollar-Buyout” nickname is making more sense now, isn’t it?

A Fair Market Value lease (sometimes called a True Lease or an Operating Lease) generally has lower monthly payments than a Capital Lease or a bank loan and it’s most often used as a shorter-term lease than a Capital Lease.  It’s usually best used for purchases of equipment that is high-tech or fast-changing like software or computer equipment.  At the end of the term, the lessee most often returns the equipment to the lessor or in some cases is granted the option to purchase the equipment at “fair market value.”

There are some distinct differences at tax time too – this is where a Fair Market Value lease tends to shine.  The FMV lease payments are 100% tax deductible as an operating expense, since the equipment is not seen as a purchase.  AND, neither the asset nor the liability needs to appear of the company’s balance sheet.   A Capital Lease, on the other hand is seen as a purchase, where the lessee is considered to be the owner of the equipment and maintains full control over the residual value.  So, the monthly payments are generally slightly higher since you’re paying for 100% of the equipment cost.  Though the payments can’t be deducted as an operating expense, the lessee does have the ability to record the equipment as an asset on their balance sheet.

What it comes down to is this:  Each type of lease may be better served for different companies and different situations.  It’s important to have a handle on your budget, timeframe, and future equipment needs before you sign a lease.  Be sure to talk to your finance provider to get the low down on which type lease might be best suited for your needs.  As always, Direct Capital’s finance managers are here to help!

Direct Capital is a leading provider of equipment leasing in the United States.

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7 Comments

  1. Great article. There are a few things however, that I think could be clarified.

    A lease with and FMV purchase option is not in and of itself an operating lease. The article seems to indicated that an FMV lease is an operating lease and thus would not appear on a balance sheet. This would be true only if the other characteristics of the lease meet the FASB definition of an operating lease (assuming US GAAP reporting).

    Additionally, your article mentions that FMV leases are for financing high tech or fast changing products. While this is true for certain high tech assets, this is almost never true for software transactions since most lessors are not part of the license chain and therefore are unable to monetize the “asset” should the lessee not renew or purchase. As a result a lessor would assume zero or near zero residual value making the cash flow difference between a buck out lease and a FMV lease basically the same. Furthermore, FMV leases are very often used with hard assets that hold their value very well (think trains, jet aircraft, and tractors). As a matter of fact most of the leveraged leases done in the US are based on this type of hard asset.

    FMV leases also don’t seem to enjoy any special tax breaks for the lessee so, I don’t understand the comment that this is where “FMV leases tends to shine”. In fact FMV leases may actually result in reduction of tax benefits since the lessee will not enjoy the depreciation benefits of the asset. For, example, in some cases the lessee would be able to write off the entire value of the asset upfront with a buck out lease while the same asset financed as an FMV lease would result in tax benefits taken over the term of the lease. In any case however, the depreciation resulting from standard MACRS in addition to the interest write off should result in tax benefits being realized earlier with a buck out lease.

    Finally, a note on tax benefits. It is important to remember that the tax benefits realized for most small to mid size business are really just time value of money benefits (and temporary cash flow benefits which result in the creation of deferred tax liabilities). That is to say, they are temporary in nature since the company is paying lower taxes today with the expectation that they will pay higher taxes in the future. The net gain to the company is the time value of money related to the delayed tax payments and the return the company can earn on the cash while they, rather than the government, holds the cash.

  2. Hi Doug-

    We really appreciate you taking the time to leave such a thoughtful comment. I really like what you have to say. We were really just trying to give a high level overview of the differences, where I think you drilled down much more into the weeds than we inteded. I think that you had a lot of great points, but we always advise our customers to consult a tax advisor for their specific situation.

  3. Evening, if I buy an existing business and re-negotiate the lease with fair market value included, what does that look like. I met a business owner who negotiated his lease that included the fmv which caused him to have a lower rent payment during some years.
    Thank you for your insight and time.

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