April 25, 2019
Ask most people and they'll probably tell you buying a car is the way to go. And from a financial perspective, it's true, provided you're willing to make higher monthly payments, pay off the loan in full, and keep the car for a few years. Leasing, on the other hand, can be a less expensive option on a month-to-month basis. It's also good if you're someone who likes to drive a new car every three years or so.
There isn’t a clear-cut answer – each scenario has its own set of pros and cons. The decision to lease or buy usually comes down to your lifestyle and how you prefer to pay for things. Ultimately, there are positives about both buying and leasing.
Car leasing was once an option reserved for businesses and customers wanting luxury cars. Today it’s common in all classes of the market, from subcompact cars to pickups and luxury SUVs. About three in ten new cars that leave dealer lots are leased. Leasing is a form of car financing where you don’t pay for the entire car. When you lease a new car, you just pay for the depreciation that occurs over the term of the lease, plus fees and interest. There's often a payment amount due at signing; the balance of the cost is paid over the duration of the contract in a series of monthly lease payments. Though the concept is simple, leasing a car is a complex transaction with its own vocabulary and a potentially confusing array of numbers.
When you purchase a car, you pay the entire negotiated price of the vehicle using cash, financing, the value of your trade-in, or a combination of all three. Purchasing cars, rather than leasing them, is still the most popular way Americans acquire vehicles.
Two primary types of leases exist for tax purposes, although every lease may contain slightly different rules and benefits within the contract:
Operating leases provide the lessee, or small business, the right to use the asset (the vehicle) for the designated lease term. However, the business owner assumes no risks or benefits associated with ownership beyond use of the asset. At the expiration of the lease term, the small business is required to return the vehicle to the leaseholder, although a purchase option may be present at or near fair market value. Business owners deduct operating lease payments as an expense.
Similarly, capital leases provide the business owner (lessee) with the right to use the vehicle. Business owners also assume some of the risks and benefits of ownership, including the ability to purchase the vehicle at a discounted price at the expiration of the lease term. The leased vehicle becomes an asset and the lease itself a liability. Business owners may deduct the interest portion of the lease and depreciate the asset value over the life of the lease.
Purchasing a vehicle requires the business owner to put it on the balance sheet as an asset and any loan used for purchase becomes a liability. The business owner enjoys all the risks and benefits of ownership with a purchase. Owners can depreciate the purchase price less the estimated salvage value over the useful tax life of the vehicle, which is typically five years. Business owners deduct interest paid on any acquisition loans. The Internal Revenue Service allows taxpayers to take a section 179 deduction in the purchase year, which offers the taxpayer the ability to deduct all or part of the vehicle purchase immediately.
The determination to purchase or lease a vehicle depends largely on each individual small business and their current cash balance and year-to-date profitability. Business owners with higher profitability may want to purchase because of the ability to use section 179 as a deduction. Small businesses with lesser profitability can take advantage of an operating lease to deduct monthly expenses and avoid the potential risks associated with ownership.
Points to Consider
Cash is the most important factor when operating a small business. Although spending cash to acquire a tax deduction (purchasing) reduces your taxable income, it does not reduce your tax directly. Consequently, consider cash position before making any purchases.
Vehicles rated less than 6,000 lbs. qualify as passenger vehicles. The IRS limits section 179 deductions on passenger vehicles. Sport utility vehicles and trucks rated 6,000 lbs. and over are allowed a deduction for 100% of the business portion of the vehicle.
Buying a car means a loan for a specific amount which you will have to pay back even if the value of the car goes below the amount of the loan. With car leasing, the residual value at the end of the lease can lower the lease cost, and if you get a closed lease you can walk away without penalty.
IMPORTANT: To get tax benefits for business use you must be able to prove the car is being driven at least 50% of the time for business purposes.
Do you have the cash for a down payment? If you are concerned about putting up cash from your business for a down payment, consider a lease. Some leases do not require a down payment, but most car loans do.
Some expenses differ between purchased and leased vehicles using the actual expense rules, and since you don’t own a leased vehicle, you can’t depreciate it. However, you can deduct the business percentage of your lease payments. There is one hitch: since the tax code limits the depreciation on “luxury” cars, it also limits (to a very small degree) lease payments on such a car. It’s called a “lease inclusion amount” and it reduces the deductible lease payments. The higher the original value of the car, the greater the amount.
There is one more difference between buying and leasing a business vehicle, which is the disposition of the vehicle. When you dispose of a business vehicle that you own, there may be a taxable gain or deductible loss. The portion of any gain that is due to depreciation will be taxed as ordinary income. When you return your leased car to the dealer, there is no taxable gain or loss.
As with most decisions in life, taxes should only be one of the considerations. Here are a few of the non-tax considerations of buying or leasing a business vehicle:
- Number of miles you drive each year – leased cars often incur extra fees for miles driven in excess of 10,000 or 12,000/year.
- How long you keep a car – do you get a new car every three-four years or keep it until its junk?
- How much do you want to spend on your monthly payments – lease payments are usually quite a bit less than monthly payments on car loan.
Whether you lease or buy a car for your business depends on cash flow, mileage, and other issues that are specific to your business. Spend the time to research both options before making a decision. Call us at 713-590-3000 and let’s talk through the details.
ABOUT THE AUTHOR
Deb's primary responsibilities are to help manage the firm's tax services for individuals, corporation, and partnerships. Her areas of expertise include providing accounting assistance for emerging businesses, tax compliance, and tax planning.