Reader expects Fair Market Value at the end of a lease to be based on value of the equipment. Tom says Fair Market Value isn’t “fair” and explains why.
Reader asks: Was wondering if you knew how to find out the “fair market value” on a machine. We’ve got a lease ending in a few months, and the leasing company is going to send me a buy-out quote. I would love to have some bargaining ammunition on my side. Thanks.
Tom responds: Well, depends on the equipment but the real issue is what you will be expected to pay and that will be 10% of the original value regardless of the condition. Also in my experience is that they usually aren’t in a bargaining mood. And that’s all because of tax rules instead of what we think when we sign a Fair Market Value lease.
Okay, first, how do you find the market value of a piece? Getting ahold of used equipment dealers and getting an estimate and/or looking at used equipment ads is usually best. Also eBay (depending on the piece) and finding other comparables like that.
Unfortunately getting dealer estimates in the area of digital do-dads is harder to do because of the franchise nature of equipment vendors – the person you are dealing with is usually the only one in the area reselling and servicing the equipment. But, you can possibly get some good information by going to a dealer somewhere outside of your area but, again, it may not matter much because of the rest of the story.
So, here’s the rest of the story …
Most think that a Fair Market Value lease to refer to, well, fair market value when it really is a tax thing so IRS rules play a big role in this.
To understand, let’s review leasing’s history real quick. Use to be business owners couldn’t borrow money from banks for equipment (what’s your bank going to do with a press), so the leasing business got started; these were people who would buy the equipment for you and then rent it to you on a monthly basis for a fixed term which was called a lease.
A benefit of leasing was the tax treatment in those days. Just like building rent, leasing payments were expensed against income as they were paid.
A second benefit from the lessor’s standpoint was the leasing company didn’t really care about the equipment. Rather, they calculated their formulas so you would pay for the equipment plus their profit in your regular payments. Thus in the beginning, business owners who leased equipment were considered to be less than credit worthy by banks and other business owners (I know I was one who leased early).
Leasing popularity was also hinder by the conventional wisdom that paying more for equipment than necessary was dumb. The fact that you could get the equipment now and use the cash flow it generated to more than pay back the investment and make a tidy profit in the meantime was overlooked until enough underdogs used leasing to expand at the expense of their competitors that the conservative competitors began to do the same.
So leasing became more and more popular.
Then it drew the attention of tax authorities who realized that the $1 buyout lease was just another form of financing. So what? Example: lease a $30,000 piece of equipment for three years from a leasing company and you’d pay about $833 a month (disregarding interest) and be able to fully deduct the payment.
However, if you borrowed $30,000 from the bank to buy the same piece of equipment, you would be forced to depreciate the equipment over a longer period roughly equivalent to its useful life (commonly five years). But you’d pay the bank over three years just like the leasing company.
So with bank borrowing, you’d pay $833 month ($30,000 / 36 payments) but you could claim only $500 a month in depreciation ($30,000 / 5 years or 60 months). That is a disadvantage to the business owner as well as the bank when compared to leasing companies.
So, two types of leasing were defined.
1) A financing lease (commonly referred to as a Fair Market lease) is one in which you end up OWNING the equipment at the end ($1 buyout) and the accounting and tax treatment was brought in line with typical bank financing. This calls for you to capitalize the equipment (put on your balance sheet the same as any other bank loan) and to claim depreciation which commonly is different than the payments.
2) An operating lease is one in which you do not own the equipment at the end and have no expectation of doing so. An operating lease is not put as a debt on the balance sheet, although all leases are footnoted in a full set of financial statements.
A good example of this is your building lease. It gives you the exclusive use for a specific period of time and then you either renew the lease or walk away. It is not capitalized (put on the balance sheet as a debt) but, as noted, is footnoted.
The question came up regarding equipment and the amount the lessor (you) could pay at the end of the lease. Tax officials concluded that the deal at the end should be an arm’s length exchange as it would be in selling any piece of used equipment and thus the term Fair Market Value came into being.
That is where the 10% comes into play. Tax rules say that the exchange at the end should be Fair Market Value or a minimum of 10% of the original value.
Net result of this is that the leasing companies pretty much now include their profit, interest and whatever in the original term of the least and then sell it to you for the minimum of 10% to meet the tax requirements.
This is why I guess that you receive an offer to purchase the piece for 10% of the original value or to extend the lease under the SAME terms for another period of time. And that’s why the actual value of the piece won’t be that material to your discussion with the leasing company.
That’s my thoughts. I hope this helps.
Tom Crouser
