Commercial vehicle leasing: Understand your options
Commercial vehicle leasing arrangements
- With open-ended leases, the lessee pays for depreciation.
- With close-ended leases, the lessor pays for depreciation.
- Operating leases do not give the lessee vehicle ownership.
- Capital leases give the lessee shared title to the vehicle.
- Coming soon: New rules say all vehicle leases will need to go on your company balance sheet.
When leasing a commercial vehicle, there are multiple arrangements that suit various business needs and objectives. If you are looking to lease a commercial vehicle for your business, you’ll need to decide whether you want an open- or close-ended lease, and whether you prefer an operating or capital lease arrangement. As each combination has different costs and benefits, carefully consider what will work best for your business.
What is an open-ended lease?
The primary difference between an open-ended and close-ended commercial vehicle lease is which party bears the cost of vehicle depreciation at the end of the lease. With an open-ended lease, you as the lessee are responsible for the residual risk.
Open-ended leases are flexible arrangements but riskier to the lessee — and consequently have a lower monthly cost. With an open-ended lease, you set the residual value of the vehicle or equipment at the beginning of the lease based on how you intend to use the vehicle. There are no mileage restrictions, and at the end of the lease you can either buy the vehicle or return it to the lessor. As the vehicle can significantly depreciate due to usage, wear and maintenance or lack thereof, however, the total cost of ownership is uncertain up front. If the vehicle value at lease-end is lower than your initially estimated residual value, you must pay back the difference. It is difficult to anticipate this residual value, hence the higher risk of an open-ended lease.
Many open-ended leases include a terminal rental adjustment clause (TRAC) that establishes the vehicle purchase price at the beginning of the lease, thus eliminating some of that risk. The flexibility and predetermined buyback price make TRAC leases a common choice for fleet vehicle acquisition.
What is a close-ended lease?
A close-ended commercial vehicle lease is more expensive and restrictive, as the residual risk is borne by the lessor. The benefit for the lessee is that costs over the course of the lease are fixed and clear, allowing you to make predictable payments without facing a financial hit from depreciation at the end of the term. Close-ended leases also give you more lease-end options to either turn in the vehicle, trade it for another or purchase it at a buyout price determined at the beginning of the lease. There are typically mileage and wear limitations, however, that can incur added costs if exceeded.
How does a capital lease work?
Commercial vehicle leases also take a capital or operating lease structure, which determines whether you as the lessee take any ownership of the leased vehicle.
A capital lease is effectively a loan, as you pay for the vehicle cost over the course of the lease, after which you typically acquire the asset. You share the title with the lessor and thus shoulder any depreciation in value. As an owner, you are entitled to claim depreciation tax write-offs, however. At lease-end, the title is either automatically transferred to you — sometimes at a cost of $1 — or you have the option to buy the asset for a low price, often 10 percent of the vehicle’s original value.
Capital leases are beneficial for businesses that require specialized equipment or vehicles that they intend to use long-term. While there is often a larger payment due at signing for a capital lease, it can be a more cost-effective arrangement in the long run as you eventually own the vehicle.
How does an operating lease work?
With an operating lease, also known as a service lease, you do not share title to the vehicle and thus don’t pay for any vehicle depreciation. Naturally, this means you cannot write off any deductions for the depreciation either, as it is retained by the lessor. At the end of the term, you have the option of continuing the lease, trading in the vehicle or buying it at its fair market value at lease-end. Open-ended TRAC leases, for example, are operating leases.
While there is often no money due at signing, operating leases are more expensive over time as you are not building equity in any asset. It allows you to preserve cash flow, however, given the relatively low up-front costs. The shorter term and lower commitment of operating leases make them ideal for businesses whose vehicles have a high turnover rate or need frequent upgrades.
Operating leases used to be characterized by the ability to keep the assets off your balance sheet. This is no longer the case following new standards introduced by the Financial Accounting Standards Board. Due to come into effect Dec. 15, 2018, for public companies and Dec. 15, 2019, for private companies, all vehicle and equipment leases must go on company books no matter their structure. For many companies, this eliminates one of the key benefits of an operating lease, which was the ability to preserve credit for core business expenses. Discuss the best option with your accounting department before making a decision.