A dollar buyout lease is a purchase on installments and an FMV lease is a rental: the difference is who owns the equipment's value at the end. A dollar buyout lease's payments repay the full cost plus a financing charge, and you buy the equipment for a nominal sum at the end; tax, accounting and lenders treat it as debt. A fair-market-value lease has lower payments because the lessor keeps the equipment's remaining value, and at the end you return it, renew or buy it at its then market value. An FMV lease suits equipment you expect to replace; for anything you will keep, it usually costs more.
- Dollar buyout lease
- Full cost repaid; you keep the equipment for a nominal sum
- FMV lease
- Lower payments; lessor keeps the residual value
- Treated as
- Buyout: a purchase and debt. FMV: usually a rental
- Who bears the resale risk
- Buyout: you. FMV: the lessor
- Right for
- Buyout: equipment you keep. FMV: equipment you replace
The real difference is who owns the residual
Every piece of equipment has a residual value: what it will be worth at the end of the lease. The two structures differ only in who owns that value, and everything else follows from it.
In a dollar buyout lease, you do. The lessor prices the payments to recover its whole cost plus its return, so when the last payment is made it has been paid in full and has no further interest in the machine. The buyout is nominal because there is nothing left to buy.
In an FMV lease, the lessor does. It estimates what the equipment will fetch at the end of the term, prices your payments to recover only the difference between today's cost and that estimate, plus its return, and takes the risk that the estimate is wrong. At the end the equipment is still its asset, and you can have it only at its then fair market value.
A dollar buyout lease is a loan with a different label. An FMV lease is a rental with an option to buy.
Side by side
| Dollar buyout lease | FMV lease | |
|---|---|---|
| Payments | Higher: repay full cost plus financing charge | Lower: repay cost less expected residual, plus return |
| At the end | Buy for a nominal amount | Return, renew, or buy at fair market value |
| Tax treatment | Generally a purchase: you depreciate, possibly under Section 179 | Generally a true lease: you deduct the payments |
| GAAP (ASC 842) | Finance lease | Usually an operating lease |
| Effect on EBITDA | None: interest and amortization sit below it | Lease cost reduces it |
| In a credit agreement | Counted as debt | Usually outside funded debt; payments are fixed charges |
| Resale and obsolescence risk | Yours | The lessor's |
| Early payoff | Payoff quote, much like a loan | Lessor's early-buyout quote, usually costly |
| Suited to | Equipment you will run for most of its life | Equipment you will replace or that ages fast |
Why a dollar buyout is a loan in lease form
Add up the payments on a dollar buyout lease and you get the equipment's cost plus interest, exactly as with an equipment loan. You bear the risk of the machine breaking, becoming obsolete or losing value, because at the end it is yours. The IRS generally treats it as a conditional sale, auditors classify it as a finance lease, and lenders count it as debt. There is no economic difference from borrowing to buy.
So why do businesses sign them? Usually for convenience. Vendor programs offer them at the point of sale, they commonly finance the whole cost including delivery and installation, and a lessor that knows the equipment well may approve a credit a bank would not. Those are real advantages. The cost is that a lease quotes a payment, not a rate, which makes it hard to compare with a loan. Work out the implied rate from the cost, the payments and the term before signing, and compare it with what an equipment lender would charge. See interest rate vs all-in cost and equipment lease vs equipment loan.
When an FMV lease is worth it: the break-even buyout
The FMV lease saves you money during the term and may cost you money at the end. Whether it comes out ahead turns on one number: what the equipment will be worth when the lease ends, compared with how much less you paid along the way.
Say equipment costs 1,000. A five-year dollar buyout lease has payments totaling 1,200. A five-year FMV lease on the same equipment has payments totaling 900, so it saves 300 over the term.
- If you return it, the FMV lease cost 900. The buyout route cost 1,200, less whatever you can sell the machine for. If it would fetch less than 300 after the costs of selling it, the FMV lease was cheaper; if more, the buyout was.
- If you keep it, the FMV lease costs 900 plus the buyout price. If the equipment is worth 350 at the end, that is 1,250 against 1,200: the FMV lease cost more, and you still own the same machine.
- The break-even is the 300 saved. An FMV lease wins for equipment you will keep only if its end-of-term value is below that saving, which usually means equipment that loses its value fast.
That is why an FMV lease suits equipment you expect to replace: technology that will be outdated, vehicles on a fixed replacement cycle, diagnostic and imaging equipment tied to changing standards. The lessor is better placed than you to resell or re-lease it, and you avoid being left with a machine nobody wants. For a press, a trailer or a CNC machine you will run for fifteen years, an FMV lease is usually the expensive way to own it.
What the accounting shows
Under current US GAAP (ASC 842), both kinds of lease longer than twelve months go on the balance sheet as a right-of-use asset and a lease liability. The difference is in classification. A lease is a finance lease if it meets any of five tests: ownership transfers at the end; there is a purchase option you are reasonably certain to exercise; the term covers the major part of the equipment's economic life; the present value of the payments is substantially all of its fair value; or the equipment is so specialized it has no other use to the lessor. A dollar buyout lease meets the purchase-option test, and often others. An FMV lease usually meets none and is an operating lease.
The classification changes the income statement. A finance lease shows interest and amortization, both below EBITDA, much like a loan and a depreciating asset. An operating lease shows a single, even lease cost in operating expenses, which lowers EBITDA. A business that reports on a tax or cash basis may not show the lease liability at all, but a lender will still ask about it.
How lenders and your debt schedule treat each
Credit agreements almost always count capital or finance lease obligations as funded debt, so a dollar buyout lease uses up the same leverage capacity as a loan. It belongs on your debt schedule with its balance, payment and maturity. An FMV lease is usually outside funded debt, but its payments count in a fixed charge coverage test, and a lender will want the lease commitments listed separately.
Both kinds of lessor commonly file a UCC-1 against the equipment; for a true lease it is a precautionary filing, but it shows up in a lien search just the same. When a new lender or an acquirer runs that search, each filing needs an explanation. A debt schedule that lists every lease, with each filing tied to the contract behind it, answers the question before a lender asks it. For paying off or restructuring leases, see refinancing equipment loans and leases.
Before you sign either
- Get the implied rate. Ask for it, or compute it from cost, payments and term. A low payment on a long term can hide a high rate.
- Pin down the buyout. On an FMV lease, ask how fair market value is set and by whom, and whether it can be capped or fixed at signing. Some leases fix a purchase price in the contract, which puts them between the two structures.
- Find the notice window. Many FMV leases renew automatically unless you give notice within a set period before the end.
- Read the return conditions. Shipping, de-installation and repair to the stated condition are usually your cost.
- Ask about early exit. Both kinds are generally non-cancellable. A dollar buyout lease can usually be paid off with a payoff quote; an FMV lease early buyout can be expensive.
- Check what the lessor files against. The filing should cover the leased equipment, not all business assets.
Common questions
- Is a dollar buyout lease the same as an equipment loan?
- Economically, yes. The payments repay the full cost plus a financing charge, you bear the resale risk, and tax, accounting and lenders generally treat it as a purchase financed with debt. The practical differences are in the paperwork, and in whether the lease's implied rate is better or worse than a loan's.
- Why are FMV lease payments lower?
- Because you are not paying for the whole machine. The lessor expects to recover part of its cost by selling or re-leasing the equipment at the end, so your payments cover only the value you use up during the term, plus the lessor's return.
- Can I take Section 179 on a dollar buyout lease?
- Generally, a dollar buyout lease is treated as a purchase for tax, so the business may be able to depreciate the equipment and use Section 179. On a true FMV lease the lessor owns the equipment and you deduct the payments instead. Confirm with your tax adviser.
- Can I negotiate the fair market value buyout?
- Yes, and the time to do it is at signing. Ask how value will be set, whether it can be capped, or whether a fixed purchase price can be written in. At the end of the term, with the equipment in place and running, you have little leverage.
- Does my bank count an FMV lease as debt?
- Usually not in funded debt, depending on the credit agreement's definitions. But the lease payments usually count as fixed charges, and the lease cost reduces the EBITDA your covenants are measured on, so an FMV lease still uses up borrowing capacity.