What Is a True Lease?
A true lease is a type of multi-year lease in which the lessor gives the lessee exclusive rights to use and possess property or equipment for a monthly fee over a specified period. Ownership rights of the asset do not pass on to the lessee.
How True Leases Work
A true lease is also known as a tax lease or a tax-oriented lease. It is referred to as true because this type of contract passes the accounting requirements for the lessor to claim any and all associated tax benefits, including depreciation deductions, on the leased property or equipment. Conversely, the lessee claims lease payments as a capital expense.
At the conclusion of the lease term, and when no extension has been signed, the lessee is responsible for vacating the property in the condition in which it was leased, or in close proximity to. In the case of leased equipment, the lessee is responsible for returning any equipment used in good standing. The lessee may be able to purchase the equipment outright in certain situations.
A true lease differs from a finance lease. Essentially, a finance lease is one where the lessor purchases the asset for a lessee and rents it to them over a defined period. The lessee makes payments that cover the original cost of the asset during the initial, or primary, period of the lease. In certain instances, there will be a larger payment made at the end of the contract, also known as a balloon payment. The lessee receives exclusive use of the asset provided they adhere to the terms outlined in the agreement.
Example: Operating Leases
Unlike a finance lease, the risks and rewards of ownership largely do not transfer over to the lessee under what is known as an operating lease. The duration of this type of lease is typically less than that of the economic value of the leased asset. At the end of the lease, the lessor would expect to be able to extract additional economic value from the asset; this is what would be referred to as the residual value.
At the start of any lease, the lessor will consider the residual value forecast for the asset at the end of the lease in an effort to set expectations for any additional value the asset could bring. Most operating leases involve assets that will have some sort of value at the end of the lease, including vehicles or heavy equipment and machinery.