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Leveraged Lease



Definition

A leveraged lease is a lease agreement where the lessor provides an asset to the lessee using borrowed funds. The lender is the one who typically receives the lease payments directly from the lessee. These payments cover the loan’s principal and interest, and the lessor receives the residual income after all obligations have been met.

Phonetic

The phonetics of the keyword “Leveraged Lease” is: /ˈliːvərɪdʒd liːs/.

Key Takeaways

  1. Financial Instrument: Leveraged leases are a type of financial instrument where a firm finances the purchase of an asset by borrowing funds. The leased asset is owned by the lessor (the leasing company) but the lease payments are passed through to the lenders.
  2. Risk and Reward Distribution: This lease agreement distributes the risk and rewards between the leasing company, the borrower, and the lender. The lessor gets to claim depreciation on the asset and is responsible for maintaining it, while the lender’s risks are mitigated as lease payments are used to pay off the borrowed funds (the loan).
  3. Tax Benefits: Leveraged leases can be highly advantageous in terms of tax benefits for the lessee. The lessee can deduct the full amount of the lease payments from their income as an expense, thus reducing their taxable income and potentially saving on taxes.

Importance

A Leveraged Lease is a significant term in business/finance because it allows companies to finance large, expensive assets, typically property, plants, or equipment, without significant upfront capital outlay. The lease structure involves a lessor, lessee and a lender, making it a complex but beneficial financial mechanism for businesses. It is crucial because it enables the lessor to claim depreciation expenses on the asset, providing significant tax benefits – while also allowing the lessee to use the asset in return for regular lease payments. This helps companies mitigate financial risks, improve their cash flow and manage their assets more effectively, making Leveraged Leases a crucial instrument in sound financial management and strategic planning.

Explanation

The primary purpose of a Leveraged Lease is to deliver a way for companies to finance the purchase of an asset while benefiting from tax advantages. It’s a type of lease agreement that involves three parties – the lessee, the lessor, and a lender. Businesses use this financing structure to acquire high-cost assets, like property, machinery, vehicles, or equipment, without having to tie up large sums of capital upfront. This allows them to keep funds free for other operational necessities. It is especially beneficial when the asset being leased has a high residual value and is subject to depreciation over time.The strategy behind a leveraged lease is for the lessor to borrow a significant portion of the purchase price of the asset, generally 70-80%, hence the term ‘leveraged’. The lessor uses the lease payments from the lessee to repay the loan. The significant advantage of a leveraged lease for the lessor is the ability to claim the depreciation of the leased asset as a tax deduction, which can be a major profit driver. Moreover, the lessee also gets to benefit by deducting the lease payments as a business expense on their tax return. Therefore, leveraged leases, although complex, can be a valuable tool for both the lessor and the lessee when used appropriately and when the financial and tax conditions are favorable.

Examples

1. Aircraft Financing: A significant proportion of commercial planes are purchased through leveraged leases. In these cases, airlines (lessees) do not want to spend their capital to purchase planes. They approach financial institutions or leasing companies (lessors) who buy the aircraft from the manufacturers and then lease them out to airlines. Airlines make regular lease payments, the lessor gets tax benefits and eventually, the airline might opt to buy the aircraft towards the end of the lease term.2. Real Estate: Real estate is another common domain where leveraged leases are used. For instance, a corporation may want to build a new headquarters but does not wish to make the large upfront capital expenditure required. A bank or financial institution may fund the construction of the building and then lease it out to the corporation. This setup allows the corporation to spread out the payment over many years, and the bank gets the benefit of depreciation and interest deductions.3. Utility Companies: Large utility companies often utilize this leasing method to finance their equipment for generating power, such as turbines or solar panels etc. The equipment manufacturer sells to a third party who, in turn, leases to the utility company. The third party, which usually involves investors, benefits from tax advantages and a steady stream of income, while the utility company gets to use high-cost equipment without a sizable upfront payment. This method allows utility companies to maintain stable and lower consumer utility rates.

Frequently Asked Questions(FAQ)

What is a Leveraged Lease?

A leveraged lease is a type of lease agreement that is mostly used in the world of finance and business. It involves a lessor, lessee, and lender, where the lessor borrows a portion of the money required to buy the asset and leases it out to the lessee.

Who are the parties involved in a Leveraged Lease?

A Leveraged Lease usually involves three parties: a lessor who owns the asset, a lessee who uses the asset, and a lender who finances the asset purchase for the lessor.

Why is a Leveraged Lease beneficial for businesses?

A Leveraged Lease allows businesses to acquire and use expensive assets without making a large initial investment. It also provides tax benefits to lessors, as the depreciation of the leased asset is used to offset taxable income.

How does a Leveraged Lease work?

In a Leveraged Lease, the lessor purchases an asset with the intention to lease it to a lessee. The lessor typically borrows a significant part of the purchase price from a lender. The lender secures their loan with the underlying asset and the lease payments.

What are the risks associated with a Leveraged Lease?

There are risks associated with Leveraged Leases, such as the possibility of the lessee defaulting on their payments. In such a case, the lessor would still be obligated to make payments to the lender.

Is a Leveraged Lease considered debt or equity?

It can be considered both. The money borrowed by the lessor to purchase the asset is treated as debt, while the equity portion is the money that the lessor has invested from their own resources.

Who gets the tax benefit from a Leveraged Lease?

In a Leveraged Lease transaction, the lessor is entitled to the tax benefits arising from the ownership and depreciation of the lease asset

Related Finance Terms

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