What Qualifies as a Capital Lease?

What is a Capital lease? 

In accounting terms, a capital lease is a contract that grants a renter access to an asset for a limited time and has the same economic features as asset ownership. To understand the capital lease in more depth, you need to understand it from two main perspectives:  

1. Transfer of lease ownership.
2. Minimum lease payment 

In the lease period under a capital lease, the lessor gives the lessee ownership of the asset. By virtue of the bargain option provided by the lease agreement, the lessee will be able to purchase the asset at a lower cost than its fair market value after the lease period.

The fair value of the leased asset is roughly represented by the present value of the minimum lease payments in a finance lease. Additionally, the lease period needs to correspond to the majority of the asset’s usable economic life. The lessee is responsible for covering the loss if the lease is terminated for any reason. The lessee is deemed to be the asset’s owner after the lease period and is eligible to deduct depreciation and finance costs.

Why is capital lease important? 

The capital lease is important because, by allowing you to add or remove equipment or relocate to a larger building if necessary, it provides you with greater flexibility in fulfilling your company’s needs. Instead of purchasing equipment, machinery, real estate, or other property, you could prefer to lease it. Due to the rapid advancements in technology, it is sometimes more cost-effective to lease than to buy certain things, which may keep your company at the forefront of its sector. You can lower your tax obligation as a lessee in a capital lease arrangement by deducting your depreciation and interest costs. 

What are the four factors for capital leases?

Any one of the following four requirements must be satisfied for a lease to be considered a capital lease:

1. 90% or more of the total present value of the lease payments over the lease period constitutes the asset’s fair value.
2. The lease is irrevocable and lasts for a minimum of 75% of the asset’s useful life.
3. You have the choice to purchase the asset from the lessor for a discounted price.
4. At the end of the lease term, the lessor must give you ownership of the asset.

Conclusion 

In this blog, we learned about the importance of capital leases and what qualifies you. A capital lease is a contract that grants a renter access to an asset for a limited time. Under a capital lease, the lessor gives the lessee ownership of the asset. Leasing provides you with greater flexibility in fulfilling your company’s needs. You can lower your tax obligation by deducting your depreciation and interest costs.