Most of us understand the process of buying and financing a car. Leasing, on the other hand, is still very foreign to us. Dealers are constantly telling us that it’s better for us to lease. However, they don’t seem to be able to explain why. The best they can do is to tell us that a lease has a lower monthly payment and that a lease is a better deal tax-wise.
This article will familiarize the reader with the economics of leasing versus buying as well as the tax treatment of a lease versus a purchase.
2. Buying a Car
Buying a car is very familiar to us. We first decide which car we want to buy. We then negotiate the best price/deal we can. We then shop for the best financing terms we can find. Based on the financing options, we decide on how much money to put down in order to make sure that the monthly payment will fit our budget.
One of our real estate clients, Jane, decided to buy a brand new Cadillac DeVille. The dealer’s sticker price (MSRP) was $40,954. Jane was able to negotiate this price down to $38,411 as well as get a trade in allowance of $10,500 on her older model Cadillac which she used as her down payment. Jane was able to get financing at 8% from her bank for a 36 month loan. Taking into account the sales tax ($3,168.91), the luxury tax ($396.99) and the license fee ($790.00), Jane’s total financing amounted to $32,266.90. This resulted in a monthly payment of $1,011.13.
3. Leasing a Car
The main reason given by most people who lease a car, as to why they lease, is to lower the monthly payments. Also, leasing usually requires a smaller down payment than financing a car.
You see, leasing versus buying a car is very much like renting versus buying a house. It is usually much easier to come up with a security deposit and the monthly rent then it is to come up with a down payment and the monthly mortgage payment.
If Jane had decided to lease the same brand new Cadillac DeVille for 36 months, and she still would put down her $10,500 trade in as a deposit, then her monthly payment would only be $396.74.
a. What’s the Catch?
Why is there such a big discrepancy between the $1,011.13 financing payment and the $396.74 lease payment?
The answer is that at the end of the financing period you own the car free and clear. During and at the end of the leasing period, the dealer or leasing company owns the car. If you want the car at the end of the lease, then you have to buy it by paying the agreed upon residual value which you signed up for at the beginning of the lease.
In a lease, instead of making payments until the loan is paid to a zero balance, your payments are structured around the predetermined end of term value or “residual value” of your new car.
b. Why Are Current Monthly Payments Based on the End Value of the Vehicle?
In most lease contracts, the dealership you arrange the lease through is not the owner. Typically, when you negotiate a price, the leasing company is agreeing to buy the car from the dealer based on the price you negotiate.
Since the leasing company is allowing you the full use of their vehicle without full payment they bear the risk. To offset this risk, they can charge you a rate factor (lease interest rate) until you pay them back.
Since the leasing company takes the risk that you will pay them back in full, they determine the structure of the lease, including the value of the car at the end of the lease, the lease factor and any mileage stipulations.
For the leasing company, a vehicle is considered an investment. The moment you drive the car off the dealer’s lot, the clock starts ticking. But they aren’t losing time, they’re losing money.
Every day the car goes down in value (it’s a depreciating asset). How quickly a car loses its value (or depreciates) over the term of a lease is very critical to the leasing company since in the end this residual value will assure their return on their investment.
c. Is Leasing Less Expensive Than Financing?
It may cost you less to drive a car on a monthly basis, but in most cases, it will cost you more in the long run.
If you make all of the scheduled monthly payments and opt to buy the car at the end of the lease, you will have paid more for the car than if you had financed it from the start.
This assumes you are going to finance the remaining balance owed (or the residual value) at the prevailing used-car interest rates.
d. Leasing Variables
Some cars are better values to lease based on consumer trends (or variables). Some of these variables include the kind of car you select and how well it holds its value, your individual driving habits and any factory-sponsored lease rate reductions.
Long before you lease a vehicle, these variables have been put into a formula to determine your monthly payments. This is the main reason why leasing is so confusing. The lending company (or lessor) determines how much a car will lose value (or depreciate) over the term (number of months) of the lease and how much the cost of borrowing money (or rate factor) will be.
4. Taxes and Buying
If you use your car in a trade or business then you are allowed to deduct the cost of operating and maintaining the car including depreciation.
If you so choose, you are allowed to claim a standard mileage allowance (32 ½ cents in 2000) for every business mile you travel. However, if it is to your benefit, you are allowed an alternative method of claiming a deduction for your actual out-of-pocket expense including depreciation. Such a deduction is limited to the business use of the vehicle (i.e. excludes commuting and personal use mileage).
More often than not, taxpayers elect to use the actual method of accounting to claim their automobile expense. Depreciation is an accounting method that compensates the owner for the eventual decay of an asset used in business. All assets are assigned a useful life by our tax code. Automobiles are regarded as having a useful life of five (5) years.
However, unlike other assets, automobiles are limited as to the amount of depreciation allowed in any one year. This limitation was originally meant to level the playing field between those who can afford an expensive “luxury” automobile and those who could not.
However, this “luxury automobile limitation,” which by-the-way regards any automobile with a purchase price of over $15,800 as a luxury vehicle, has practically speaking, affected almost all of us who use and deduct the use of our automobiles in our trade or business.
It is this limit on the depreciation deduction that can have a significant effect on the comparison of the tax benefit derived from buying versus leasing a vehicle. Depreciation for vehicles placed in service during 1999 will be limited to $3,060 for the first tax year; $5,000 for the second tax year; $2,950 for the third; and $1,775 for each succeeding tax year.
If Jane uses her brand new Cadillac DeVille 80% in her real estate business in 1999, then the maximum depreciation deduction that Jane can claim in 1999 is $2,448 (80% of $3,060).
5. Taxes and Leasing
By and large, the tax rules for leased business autos are much simpler than the rules that apply if the autos are purchased.
Instead of dealing with complex depreciation limits for luxury autos, the business lessee deducts the business use percentage of lease payment, and winds up with a (usually small) inclusion amount — an add back to income — that varies with the auto’s FMV, the year it was leased, and length of the lease.
The leasing rules are a model of simplicity. The only exception is that those who lease cannot take advantage of the standard mileage allowance but instead must use the actual method of accounting.
To calculate your leasing expense deduction (unlike depreciation), you simply multiply your annual lease payment (including the amortized portion of your down payment) by your business use percentage.
If the FMV of the auto when the lease was signed exceeded the luxury automobile dollar threshold then you must include a certain amount in income during each year of the lease.
If Jane uses her brand new leased Cadillac DeVille 80% in her real estate business in 1997, then the maximum leasing expense deduction that Jane can claim in 1997 is $7,309 (80% of $396.74 times 12 plus $10,500 divided by 3). However, Jane must also include in income $162 (80% of $202) for a net deduction of $7,147.
As you can see, leasing wins by a big margin over buying with regards to the tax deductible expense. $7,147 versus $2,528!
a. Payments at Lease Inception
Lessees often are required to make a cash payment when an auto lease is signed. Often, these payments “buy down” the monthly payments on the auto, and, as such, are the equivalent of advance rent, a cost that is deductible over the lease term.
Cash payments made at the inception of an auto lease should, like advance rent, be amortized over lease term and should be deductible to the extent the regular lease payments are written off.
For example, if a self-employed person consistently uses a leased auto 80% for business and 20% for personal driving, then 80% of the amortized amount should be deducted.
b. Excess Mileage Charge
When an auto is returned to the lessor, a lessee may have to pay a charge for mileage in excess of the figure allowed under the lease (e.g., 12 cents for each mile over 30,000). If the auto was used 100% for business, the business lessee simply will deduct the excess mileage charge as a business expense.
c. Fee for Early Lease Termination
A lessee who has to walk away from an auto lease before the end of its term will pay a substantial penalty for doing so. Lease termination payments generally are deductible, so the business lessee’s penalty for terminating an auto lease should be 100% deductible if the auto was used 100% for business.
Why is leasing so hard to understand? The reason most people don’t understand leasing is because they aren’t familiar with the idea behind it. The most important thing to remember before you lease a car is to know the right questions to ask. The following list of questions should be answered before you lease a car:
- What is the initial cost of the car that I am leasing? (CAP Cost)
- What is the lease rate I am being charged by the leasing company? (Cost of borrowing money)
- This lease is for how many months? (Length of term)
- How much money do I owe at the beginning of the lease? (Entry fees)
- How much do I owe if I want to buy the car at the end of the lease? (Residual value)
- What is the maximum mileage this lease allows without a penalty?
- If I go over the mileage limit, how much will I be charged for extra mileage?
- Does the amount of insurance coverage I carry increase if I lease?
- Does the leasing company offer standard GAP insurance? (To pay off the loan in full in case of an accident)
- What happens if I decide to terminate the lease early? (Pre payment penalty)