Printer Friendly

Purchase vs. lease of an automobile.

Unfortunately, there are no general rules about who should buy and who should lease an automobile. Each situation must be analyzed on a caseby-ease basis. For most individuals, the objective is to obtain a car for the lowest possible aftertax cost while avoiding any unpleasant surprises.


Purchasing a car is a straightforward transaction. Ignoring trade-ins, the car's price is known and the buyer either pays cash or makes a down payment and finances the balance. It's advisable for potential buyers to check car loan rates and terms with local lenders and compare them with dealer financing. With many car dealers offering low-rate financing or rebates, potential buyers may do better taking rebates and financing the purchase themselves. And it's important to do more than just compare monthly payments; the annual percentage rate (APR) on each financing option must be computed.


Leasing a car can be a complicated transaction; sophisticated financial calculations may be required to determine the best option. The first step in car leasing is the same as in buying-shop for the best deal. And just as a car's price and options are negotiable for a purchaser, lease terms also can be negotiated. To make this easier, the sidebar on page 39 defines some key leasing terms.

When analyzing a lease transaction, it's best to begin by finding out the car's capitalized cost. This is essentially the amount for which the dealer is selling" the leased vehicle. This should compare favorably with the cost of the same car in a cash transaction.

The next critical factor is the car's residual value (expected worth when the lease expires). This amount frequently is expressed as a percentage of the car's original price. The residual value should compare favorably with the book values of corresponding used cars when the lease expires.

The car's residual value is a key element that will make monthly lease payments less than the corresponding payment to buy the same car. When a car is purchased outright, the buyer pays for the entire vehicle; with a lease, the lessee pays only for depreciation during the lease term, plus an interest equivalent. The greater the vehicle's residual value, the better the lease transaction will be for the lessee.

A high residual value is the principal reason why luxury earmakers such as Mercedes Benz can advertise monthly lease payments that seem so low. In a manufacturer-sponsored lease transaction, when the dealer is motivated to "do the deal," the car's residual value may be set higher than its historical resale value to reduce lease payments. The remaining data needed to analyze a lease-monthly payment and lease term-are obtained easily; no calculations are required.


Armed with the necessary independent variables, the lease's implicit interest rate (the rate at which the lessor "lends" money to the lessee) can be calculated. A financial function calculator or computer program likely will be necessary to make the computation. The implicit interest rate should compare favorably with the rate lenders are currently offering on car loans.

It's also possible to evaluate the proposed transaction by doing a comparative present-value analysis of buying a car versus leasing. The net present value of a purchased car can be compared to the net present value of future lease payments. Exhibit 1, above, makes such a comparison.


Educated consumers mill find important information in the small print at the bottom of automobile lease advertisements (and hopefully in the lease itself).

* Excess mileage charges. Most leases specify a per-mile charge (often $. 10 to $.15) on mileage exceeding the allowance (usually 45,000 to 50,000 miles). This should be compared to the vehicle's estimated use. For frequent drivers, the added cost can often be considerable.

* Security deposit. Most leases require a refundable deposit equal to one month's (or more) lease payment. The time value of money must be considered because the lessee loses use of the funds for a period of time, The larger the required deposit, the less attractive the deal.

* Capitalized cost reduction. This is a fancy term for a nonrefundable payment required at lease inception. The higher the amount, the lower the advertised monthly lease payment.


Not all lease terms are included in promotional material. Prospective lessees may need to do some additional homework to find out about other terms, including

* Availability of gap" insurance. In the event the car is stolen or damaged beyond repair, conventional insurance may cover only its replacement value, which could be thousands of dollars less than the unpaid lease balance. For a relatively small one-time premium, the lessee often can insure against this risk.

* Lease termination before expiration date. How much would it cost the lessee to terminate a three year lease after only two years? Some lease agreements provide for prohibitively high early-termination payments, making the lease essentially noneancelable.

* Excess wear-and-tear charges. How is "excess" defined? How are the charges calculated?


If the car is to be used for business, income tax considerations take on added importance.

Since 1984, federal tax laws have significantly reduced the opportunities and benefits of claiming deductions for business use of a car. In addition to tougher substantiation requirements, deductions have been curtailed. For a purchased vehicle used 100% for business, Internal Revenue Code section 28OF limits depreciation deductions to

* First year: $2,660.

* Second year: $4,200.

* Third year: $2,550.

* Each succeeding year until fully depreciated: $1,475.

For a vehicle used at least 50% for business, the deduction is based on the business-use percentage multiplied the amounts listed above. If business use is below 50%, no depreciation deduction is allowed. Under these rules it obviously will take many years to write off a luxury car. If the vehicle purchase is financed, interest will be fully or partially deductible based on the business-use percentage. Interest incurred to purchase a car for personal use is no longer deductible.

Although Congress intended to treat car lease transactions on terms similar to purchases, leases have an inherent advantage. in general, if a business-use vehicle is leased by a company (the recommended approach) or by an individual, the laws favor the lease transaction over an outright purchase by allowing larger annual deductions.

A business leasing a car can deduct the full Payment subject to addback of an amount taken from an annually issued IRS table under temporary regulation section 1.28Of-7T(a)(2)(iv), multiplied by the business-use percentage). Personal use is reported by the company on the employee's W-2 form as additional compensation. The amount is derived from the IRS'S table of annual lease values and multiplied by the personal use percentage.

To determine the additional compensation the employee must declare, the employee should use the IRS table of annual lease values based on the car's fair value at lease inception. The table amount is multiplied by the employee's personal-use percentage.

An employee who personally leases a business-use car deducts a portion of the lease payment based on the business-use percentage. Individual lessees also are subject to the income add-back under temporary regulation section 1.280F7T(a)(2)(iv).


Leasing a car requires at least as much shopping and negotiation as buying one. Unfortunately, there is no shortcut to a good deal.

Among the factors favoring a cash purchase are

* The buyer intends to keep the car for a long time, perhaps five years or more.

* The car will not be used for business.

* The buyer prefers to avoid making monthly payments.

Among the factors favoring a lease are

* The car will be replaced in a relatively short period of time, say within four years or less.

* The car will be used partially or totally for business.

* The buyer prefers to make monthly payments or does not have the cash to buy the vehicle outright.

Exhibit 2, page 38, companies a business's purchase and lease of an automobile. n


* Capitalized cost. Car value at lease inception. This is synonymous with present value or the price of the car in an outright sale.

* Closed-end lease. A lease that provides, at expiration, for the lessor to take back the car. The lessee has no further rights or obligations.

* Implicit interest rate. The unstated interest being charged the lessee. Mathematically, it is the rate that causes the sum of the present values of the rents payable and the residual value to equal the capital cost (present value) of the leased vehicle.

* Lease term. The tune period the lease is in effect. n open-end lease. A lease that provides, at expiration, the opportunity for the lessee to purchase the car or to extend the lease term.

* Residual value. The estimated car value at lease expiration. The amount may be either guaranteed or unguaranteed if guaranteed, the lessor assures the lessee the car will be worth at least the agreed-on amount at lease expiration; if unguaranteed, the lessee bears the risk of the car's final value.
COPYRIGHT 1992 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
Printer friendly Cite/link Email Feedback
Author:Levy, Gregory M.
Publication:Journal of Accountancy
Date:Mar 1, 1992
Previous Article:Is there a gap in your GAAP library?
Next Article:Community foundations (or how to give away your cake and eat it, too).

Related Articles
GM sales a barometer of local economics.
Chrysler's sales, leasing figures match 1989's; dealers optimistic.
Statement by Griffith L. Garwood, Director, Division of Consumer and Community Affairs, Board of Governors of the Federal Reserve System, before the...
The lowdown on leasing.
Tax Court holds income forecast method not proper for rent-to-own company.
Wells buys Parsippany building. (Suburban Markets).
Bank subsidiary's LKE program qualifies under Sec. 1031.
Ford lessees to receive restitution.
Transportation risk management and insurance--avoiding gaps and traps: risk management.

Terms of use | Copyright © 2016 Farlex, Inc. | Feedback | For webmasters