LEASE VS. BUY: EQUIPMENT, CARS AND BUILDINGS

R. F. Willeford, MBA, CPA/CFP
 

EQUIPMENT

            More than half of all equipment acquisitions are financed by leasing companies, so you need to be able to make an informed decision when this important decision arises.

A lease is not a lease is not a lease…  Most folks equate “leasing” with “renting”, but this may not be true. There are two kinds of leases: an “operating” (true) lease or a “financing/capital” (purchase) lease. The operating lease is the “rental” approach. It is characterized by an option to buy the asset at the end of the term  for fair market value, with a minimum payment of 10%. In such an operating lease arrangement, you can fully deduct the monthly lease payments as you pay them. Since you do not own the property, you do not depreciate it.

            The financing or capital lease is similar to using a bank loan to make an outright purchase. (This may also be called a Conditional Sales Contract.) Like a typical loan, there is no buy-out at the end because you own the property from the beginning. This means you depreciate the property and deduct only the interest part of the payments. The leasing company does not care which approach you use, and they typically give you several variations of both options.

            R Tip:    Sometimes it pays to use a true lease to pay for building improvements. This avoids

                            the requirement to depreciate over 39 years!  

            W Trap    Sometimes there is a requirement vs. an option to pay 10% at the end. This is not a true lease!

            Example: Assume you want to finance $100,000 equipment over 5 years. A 100% bank loan would require monthly payments of $2,052 at 8 1/2%, while a true equipment lease would be $1,997 at 10%. Assume you will buy the equipment for $10,000 at the end of the lease, and that you are in the 31% federal and 6% state marginal tax brackets. Should you choose the loan or the true lease? See the comparative table below.

            R Tip:    To be conservative, I have not assumed any first-year Section 179 depreciation deduction or

                            ADA credit. Those items would reduce the net cost of buying even more.

            W Trap    Beware of “interest” rates being quoted. You want a true effective rate, not some

                             bogus “streaming” or other kind of rate. Have your CPA calculate true rates for you.

                                                            Lease vs. Buy Comparison

                                                   Total               Tax             After-tax         6% Present

                                                Payments        Saved              Cost                 Value   

True Lease     129,797           -45,611            84,186            72,276

Buy                 123,099           -43,257            79,842            69,565 

            If cost is your main criteria, you should choose the purchase option, and here’s why: taking into account the total amount of payments, the timing of the payments and the timing of the deductions, (and assuming you will invest any early savings), the lease option costs $2,711 more that the purchase option.

            Let me explain. First of all, a superficial look at the higher Total Payments of $6,698 above do not tell the whole story. The higher payments result in higher tax savings of $2,354, so the net after-tax difference is only $4,344. However, that is still not the whole story—this does not take into account the timing of when you make the payments and when you get to enjoy the tax deductions: the “time value of money”.

            For instance, if you are given the choice of receiving one dollar to invest now or the same one dollar to invest a year from now, you would prefer to have the dollar now so you can invest it sooner. In fact, if you can get 6% investment return, you would say that receiving the dollar a year from now is the same as getting about $.94 today. (You can invest the $.94 at 6% and have the dollar in a year.) We say that $.94 is the Present Value of the dollar in one year, assuming 6% return.

             So, taking into account the timing of payments and deductions, and assuming you will invest any early savings, the lease option still costs $2,711 more.

So why ever lease? Potentially, there can be some significant advantages. At a minimum, leasing offers the traditional tradeoff of convenience vs. cost: leasing companies can typically offer more flexible terms than a bank. In addition, leasing is often the only way to get a transaction financed period, regardless of the cost.

            Typically, a bank is happy to make you a loan if you have plenty of collateral (the classic case of being willing to lend money to folks who don’t need it!) Thus they may limit a loan to 80% of the cost of the equipment (hence my 100% financing assumption above may not be valid!) In the case of a practice purchase, it becomes even harder to get bank financing, since there is not much tangible equipment or other collateral as security. This is why a bank often asks for a cosigner to guarantee the loan, or they want a mortgage on your home.

            There is a big “however”: if you have a strong personal relationship with an individual banker, that banker has some latitude and may lend on your character and future cash flow. (Needless to say, maintaining such a relationship is more important than always chasing a ¼ point interest savings by jumping from bank to bank.) You may also find more flexibility when dealing with a local or small regional bank. Even the large banks go through cycles of seeking out healthcare business, and may even have special departments to handle physicians and dentists.         

            If you find a bank that will make the loan at all, they typically do not offer the same flexible payment options as that of a leasing company. While a bank may offer you a period of paying “interest only”, a leasing company will customize graduated payments to meet your needs. I.e., they may have zero payments for 3 months, then partial payments for another 3 months, etc. Keep in mind, there is no free lunch; so have your CPA calculate the true interest cost associated with this flexibility. Be aware, banks will typically avoid making the loan for over 5 years. A leasing company will easily go 7 or 10 years.

            R Tip:    A lease may not affect your banking credit, since a lease does not show up

                           as a liability on your balance sheet or on your credit report.

            W Trap    Determine what the prepayment terms are in case you want to payoff early!

AUTOMOBILES 

            This truly is the tradeoff of cost vs. convenience. If you equate “cost” with “monthly payment”, then a lease certainly looks attractive. In fact, if you insist on driving a new car every few years and assume you will be making payments forever anyway, then a lease my not be all bad. But if you prefer the financially prudent approach of driving a car for a long time, you may have already discovered the problem with leasing: in exchange for your low payments, you do not own anything! (In fact, the leasing companies are now in financial trouble because they set the residual values unrealistically high in order to keep the monthly payments low. Now they are discovering that neither the car driver nor the general marketplace will pay those prices.)

            There are several gotchas to content with: you or a friend have already discovered that you can’t just “cancel” a lease in the middle and walk away. You have essentially signed a long term “financing” agreement. The payoff amount required to get out of a lease is typically more—and often much more—than the car is worth. Hence the expression being “upside down” in your lease. Guess who pays the difference if you “total” the car in a wreck, and the insurance only pays for the car’s depreciated value vs. what you owe…. 

            Also, you may not be finished after all the payments have been made: you may have to pay for “excess” miles you put on the car. Your limit may have been as low as 12,000 miles per year. Unless you can walk to work, that is not many miles these days. 

            So, what about the tax benefits? First of all, the business portion of a vehicle is deductible whether you own it or lease it (or whether it is owned/leased by either you or your corporation, for that matter). Business use is business use. Some of you may be astute enough to know that the IRS limits the depreciation to the equivalent of a $15,000 car, and you are hoping that a lease can skirt these limitations. Sorry: the IRS limits the amount of the lease deduction in a similar manner. (In truth, the lease limitation is not quite as onerous as the depreciation limit, so there is a minor advantage to leasing.)

            Leasing may make sense if you trade cars regularly AND do not put over 15,000 miles on the car annually. The bad news is that, if that describes your habits, you may have bigger financial issues to deal with! Remember, the great investor Warren Buffet buys and drives used Fords…..

OFFICE BUILDING

            From the purely financial standpoint, the lease/buy decision depends on how long you plan to keep the building and how much it costs to build. In this analysis, the intangibles like desiring to be in better space, to be in a different part of town, to attract new/different patients, etc. are not considered. The following tables give you a quick rule of thumb as a starting point, and they do take into account taxes and the time value of money.

The tables assume you will sell the building when you quit practice, along with the following assumptions:

            Increase space from 1,800 square feet to 2,400 square feet, since most folks expand when building.

            Increased property tax and utilities as an owner equals $2,000.

            Increase rent, taxes, utilities and building value at 3% per year.

            Invest savings at 6% per year.

            20 year building loan at 11% to be conservative.

            40% income tax bracket.

            25% Fed/state capital gain tax on sale of building.

            NO increase in production—very conservative.

                                                                 Break-Even Rent Cost

                                                     It pays to build if monthly rent exceeds:

            Stated another way, the table below shows how much you can spend on a building regardless of your number of square feet. (The figures still assume a 30% increase in size.) For example, if you are going to own the building 15 years and you are currently paying $2,000 monthly rent, you could spend about $400,000 ($2,000 x 200) on a building and break even in the long run, considering the ultimate gain on the sale of the building.

                  How Much You Can Spend to Buy?

            This amount times your current monthly rent: