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Farm Credit Leasing

Leasing Terms

Following are terms and definitions most commonly used by the leasing industry and reflecting our perspective.

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Advance Payments – One or more lease payments that are paid to the lessor at the beginning of the lease term. Lease structures commonly require one payment in advance. Also known as Advance Rents.

Alternative Minimum Tax (AMT) – The AMT is like a penalty tax because a taxpayer must pay the higher of its regular tax or AMT liability. The corporate AMT rate is applied to a different, typically higher, taxable income than for regular taxes. The Tax Reform Act of 1986 substantially modified the AMT, which must be calculated for all taxpayers.

Bargain Purchase Option – An option established at lease inception allowing the lessee to purchase the equipment at the end of the lease term at a price that is fixed sufficiently below the expected fair value, so that purchase appears to be reasonably assured.

Bargain Renewal Option – An option for the renewal of a lease for a rental sufficiently lower than “fair rental” when exercisable, so that at the inception of the lease, renewal appears to be reasonably assured.

Bonus Depreciation – Also referred to as the “economic stimulus package.” In general, this provides added depreciation benefits to taxpayers acquiring qualified assets, or taxpayers who enter into binding contracts to acquire qualified property in the eight-year period following Sept. 11, 2001. Specifically, it currently permits a taxpayer to take an added depreciation allowance equal to 50 percent of the adjusted basis of the qualified property in the year in which the property is placed in service. This program is scheduled to end for assets placed in service after December 31, 2009.

Broker – See Lease Originator.

Broker Fee – See Origination Fee.

Bundled Lease – A lease that includes additional services such as maintenance, insurance and property taxes that are paid for by the lessor, the cost of which are built into the lease payments. Synonymous with Full-Service Lease.

Buy Rate – A base rate of return offered by a funding source that excludes other origination or documentation fees.

Capital Lease – For accounting purposes (FASB13), a lease is classified and accounted for by a lessee or lessor as a capital lease if it meets any of the following:

  • The lease transfers ownership to the lessee at the end of the lease term.
  • The lease contains an option to purchase the leased property at a bargain price.
  • The lease term is equal to 75 percent or more of the estimated economic life of the property (except for used property leased in the last 25 percent of its useful life).
  • The present value of minimum lease payments is equal to 90 percent or more of the fair market value of the leased property (except for used property leased in the last 25 percent of its useful life).

Capitalized Cost – The cost of equipment to be leased plus any other “initial direct costs” that may be capitalized. The total capitalized cost (or basis) is the amount upon which the tax benefits on the equipment are based.

Casualty Loss – Loss or irreparable damage to the leased equipment.

Certificate of Insurance – Document signed by lessee’s insurance agent certifying appropriate insurance coverage of leased equipment.

Closed-End Lease – A lease in which the lessor assumes the risk of depreciation and residual value. The lessee bears little or no obligation at the conclusion of the lease.

Conditional Sales Contract – An agreement for the purchase of an asset in which the lessee is treated as the owner of the asset for federal income tax purposes (thereby being entitled to the tax benefits of ownership, such as depreciation) but may not become the legal owner of the asset until all terms and conditions of the agreement have been satisfied. See Lease Purchase.

Delivery and Acceptance – A document which is signed by the lessee to acknowledge that the equipment to be leased has been delivered and is acceptable. Many lease agreements state that the actual lease term commences once this document has been signed.

Depreciation – A reasonable allowance for exhaustion, wear and tear, and obsolescence of equipment used in a trade or business. As a periodic item of expense, it allows the owner of the equipment to recover the cost of the equipment over its useful life. Depreciation deductions taken on the owner’s tax return are sometimes referred to as “tax depreciation.” Depreciation expenses listed in the owner’s financial statements are sometimes referred to as “book depreciation.”

Direct Finance Lease – This is a capital lease for accounting purposes. The lessor is the owner of the asset. For financial reporting issues, it is a capital lease. The accounting income statement is basically a principal and interest amortization schedule. The lessor’s income is interest earnings from an investment.

Discount Rate – A certain interest rate used to bring a series of future cash flows to their present value. Present value states payments in current or today’s dollars. Use of a discount rate removes the time value of money from future cash flows.

Disposal – The eventual sale or salvage of leased equipment upon its return to the lessor.

Down Payment – An amount paid in cash to a dealer or manufacturer that is deducted from the price of new equipment.

Early Buyout Option (EBO) – A point, or points, in a lease prior to the final scheduled lease payment, where the lessee can exercise a purchase option. For the lessee, the primary reasons for the use of an EBO is to allow the lessee to evaluate the lease rate at a known purchase option, and to lock in a known purchase amount, which limits their risk on a fair market value residual. The incorporation of a properly structured EBO with a Fair Market Value (FMV) purchase option can reduce the lessor’s end-of-lease residual risk and tax risk.

Early Termination – When the lessee terminates the lease prior to the end of the lease term stated in the original lease contract or subsequent agreement. This may result in an early termination penalty to the lessee.

Early Termination Option (ETO) – A one-time option to terminate the lease and surrender, not purchase, the equipment upon payment of a fee. Typically used to allow the lessee to qualify a lease as an operating lease.
Effective Lease Rate – The interest rate to the lessee considering the cash flows resulting from a lease transaction. To compare this rate with a loan interest rate, a lessee must include in the cash flows any effect the transactions have on federal tax liabilities.

End-of-Lease Options – A description of the lessee’s equipment disposal options at the end of the lease. Common end-of-lease options include purchasing the equipment, renewing the lease or returning the equipment to the lessor.

Estimated Residual Value – The Fair Market Value of the lease equipment at the end of the lease term as estimated at lease inception; calculated in constant dollars excluding inflation or deflation.

Equipment Cost – “Capitalized cost” of equipment.

Equipment Specifications – A specific description of a piece of equipment that is to be acquired, which could include, but is not limited to, equipment make, model, configuration, capacity, optional equipment and so forth.

Equipment Upgrade – An option which allows the lessee to add equipment to an existing piece of leased equipment in order to increase its capacity or improve its efficiency.

Equity – Funds invested in a lease by the lessee in the form of cash or trade value.

Equity Investor – An entity which provides equity funding in a lease transaction, and thereby becomes the owner of the leased equipment, and the lessor.

Estimated Useful Life – The period during which an asset is expected to be useful in trade or business. This is used for purposes of calculating the maximum allowable term of a lease, to determine whether or not the lease is a capital lease, and to determine the method of depreciation for a capitalized lease asset. It may or may not be the same as the life used for income tax purposes. 

Fair Market Value (FMV) – The value of a piece of equipment if the equipment were to be sold in a transaction determined at arm’s length, between a willing buyer and a willing seller, for equivalent property under similar terms and conditions.

Fixed Purchase Option (FPO) – An option to purchase the leased property at the end of the lease term for a specified percentage of the original cost or specified dollar amount. In order to protect the tax characteristics of a true lease, an option to purchase equipment from a lessor by a lessee, granted at the beginning of a lease, cannot be at a price less than its estimated fair market value at the time the right is exercisable.

First Amendment Lease – See Purchase or Renew Only (PRO).

Fixture Filing – Document filed publicly stating the lessor’s interest in leased equipment that is attached to real estate. See UCC Financing Statement.

Guideline Lease – A tax-oriented lease which complies with all of the IRS guidelines for a “true” lease as set forth in Revenue Procedure 2001-28.

Guaranteed Residual Value – Guarantee to the lessor that the leased equipment will be worth a certain amount at the end of the lease term by a lessee or an unrelated third-party (e.g. an equipment manufacturer or residual insurance company). The guarantor agrees to reimburse the lessor for any deficiency if the leased equipment is sold for an amount below the guaranteed residual value.

Guaranty – Written promise by an individual or company that all lease obligations, including payments, will be fulfilled by the lessee.

Harvest Pay – Harvest Payment allows agriculture producer lessees to acquire equipment when they need it (during production) and delay payments until they have the cash (after harvest). Lessees can choose to delay the first level lease payment up to six months. Additional payments then follow at annual or semi-annual intervals, making it possible for lessees to continue matching equipment payments to their cash flows. This is also referred to as seasonal payments. 

Initial Direct Costs – Incremental costs incurred by a lessor in connection with acquisition of the equipment, and which may become a part of the capitalized cost of the leased equipment. These may include broker fees, freight, installation, etc.

In-Service Date – The date on which the lessee accepts the equipment from the manufacturer or vendor as ready for use.

Interim Interest – Interest accrued on progress payments.

Interim Period – The time between the in-service date of a lease and the beginning of the scheduled lease term. Typically, this is a fraction of a month.

Interim Rental – Daily rent accruing from the in-service date to the beginning of the scheduled lease term. Interim rentals are based on a 30-day month/360-day year with actual days used to calculate the rent required. Interim rentals are simply a daily charge for equipment use and do not affect lease amortization.

Internal Rate of Return – See Yield.

Lease – An agreement in which one party, the lessor or owner of the equipment, permits another party, the lessee, to use the equipment for a specified period of time in exchange for a series of payments.

Lease Agreement – The contractual agreement between the lessor and lessee, which sets forth all of the terms and conditions of the lease.

Lease Amortization – See Unamortized Lease Balance.

Lease Documents – The written forms which evidence the lease transaction, including but not limited to the lease agreement, equipment schedule(s) and delivery receipt.

Lease Origination – The process of discovering (through a sales force), developing and consummating new lease transactions. Steps in the process could include, but are not limited to, prospecting for new lease business, pricing potential transactions, credit review and documentation.

Lease Originator – A party that brings the lessee and lessor together, but has no continuing involvement in the lease transaction after the closing. Also known as the Broker or Independent Originator.

Lease Purchase – A lease agreement in which the lessee is treated as the owner of the asset for federal income tax and financial accounting purposes, but who will not become the legal owner of the asset until all terms and conditions of the lease agreement have been satisfied. See Conditional Sales Contract.

Lease Rate Factor – The rental payment on $1 of equipment cost. The lease rate factor multiplied by the equipment cost gives the lease rental payment.

Lease Term – Includes the period of time from the in-service date to lease termination.

Lease Terms – Conditions governing the lease transaction.

Lessee – The user of the equipment being leased.

Lessor – The owner of the equipment being leased to a lessee or user.

Limited Use Property – Property that cannot be used after lease expiration in a commercially feasible manner by anyone other than the lessee (or a related party).

Master Lease – A lease arrangement whereby additional equipment can be made subject to an existing lease contract merely by describing that equipment in a new schedule executed by the parties. To be contrasted with a lease contract that evidences a one-time transaction involving specific unit or units of equipment.

Minimum Lease Term – The fixed non-cancelable term of the lease. The minimum term begins at the in-service and ends on a specific date. Minimum and scheduled lease terms may be equal. The minimum term allows the lease to qualify under the 90% test as an operating lease for accounting purposes (FASB13).

Modified Accelerated Cost Recovery System (MACRS) – A method of tax depreciation introduced by the Tax Reform Act of 1986 and applicable to most equipment placed in service after 1986. It replaced the ACRS method of depreciation.

Money-Over-Money Lease – See Non-Tax Lease.

Net Lease – A lease in which all costs in connection with the use of the equipment, such as maintenance, insurance, and property taxes are separately paid for by the lessee, and are not included in the lease rental paid to the lessor.

Non-Tax Lease – A type of lease in which the lessee is, or will become, the owner of the leased equipment, and is therefore entitled to all the risks and benefits (including tax benefits) of equipment ownership. Also referred to as a Money-Over-Money Lease.

Off-Balance-Sheet Financing – Any form of financing, such as operating lease, which, for financial reporting purposes, is not required to be reported on a lessee’s balance sheet.

Open-End Lease – A lease in which the lessee guarantees the lessor will realize a minimum value from the sale of the asset at the end of the lease. If the equipment is not sold for the agreed residual value, the lessee pays the difference to the lessor. If the equipment is sold for more than the agreed residual value, the lessor pays the excess to the lessee. The lease is called an “open-end” lease because the lessee does not know the extent of its liability to the lessor until the equipment is sold at the end of the lease. The lessee’s liability is “open-ended.” The term is commonly used in automobile leasing. See Terminal Rental Adjustment Clause (TRAC).

Operating Lease – The definition depends upon the context in which it is used. For financial accounting purposes (FASB13), an operating lease is a lease which does not meet the criteria of a capital lease or direct financing lease; this lease is our primary context of use. Secondly, it is used generally to describe a short-term lease where a user can acquire use of an asset for a fraction of the useful life of the asset. Additionally, it is used for a lease in which the lessor provides services, such as maintenance, insurance and payment of personal property taxes. Finally, the term “operating lease” is derived from short-term leases of equipment in which an operator is provided by the lessor, such as leases of trucks and construction equipment.

Origination Fee – Fee paid to a lease originator or broker by the lessor for their role in facilitating the lease transaction.

Payoff – When the lessee purchases the leased asset from the lessor prior to the end of the lease term. See Early Termination.

Payments in Advance – A payment stream in which each lease payment is due at the beginning of each period during the lease.

Payments in Arrears – A payment stream in which each lease payment is due at the end of each period during the lease.

Present Value – The value of a sum of money, received or disbursed at some future date, stated in today’s dollars. The future sum is lessened by some factor (based on the “discount rate”) to allow for the changing value of money over time.

Pricing – Structuring a lease transaction to arrive at the periodic rental amount to charge a lessee. A lessor must factor in many variables, which may include lease term, lessor targeted yield, origination fee, residual value and tax benefits.

Priced (Booked) Residual – The value of the lessor’s remaining investment in the leased equipment at the conclusion of the lease term used in the lessor’s pricing formulas. Priced (booked) residual is usually expressed in terms of a percentage of a capitalized cost.

Pricing Matrix – Schedule that includes multiple lease factors based on different yields, terms, residuals, pricing frequencies and/or origination fees which is used to communicate lease pricing.

Progress Payments – Used on a case-by-case basis where a number of items of equipment to be leased within a single contract are delivered over a period of time. The period runs from payment for the first piece of equipment until the equipment is placed in-service. Also known as Interim Funding.

Proposal – A lessor’s indication to a lessee as to the approximate terms and conditions of a potential lease financing, which typically includes the lease payment amount, lease term, fees, deposits and so forth. A proposal is typically subject to the lessor’s approval of credit and equipment.

Purchase Option – An option in the lease agreement which allows the lessee to purchase the leased equipment at the end of the lease term. The option is stated at either a fixed amount or at the future fair market value of the leased equipment. The option price (if fixed) is stated as a dollar amount or percentage of the capitalized equipment cost.

Purchase Order Assignment – A document which transfers all rights contained in a purchase order for equipment (for example, to purchase the equipment at a certain price with certain terms) from the lessee to the lessor, enabling the lessor to purchase the equipment from the manufacturer and lease it to the lessee.

Purchase or Renew Only (PRO) – The PRO is used in conjunction with a Fixed Purchase Option or Fair Market Value (FMV) lease. At the end of the base lease term, the lessee doesn’t have a surrender option for the equipment leased. At lease expiration, the lessee can either purchase the equipment for the stated option or renew the lease for a defined period, usually 12 to 24 months, after which the lessee has the opportunity to purchase the equipment at FMV, renew the lease or surrender the equipment. Within the leasing industry, this structure is often called a First Amendment Lease.

Put Option—Purchase Upon Termination – The right to force an equipment sale at a predetermined price at the end of the lease term.

Remarketing – The process of selling or leasing the leased equipment to a party other than the lessee at the end of the lease term. The lessor can remarket the equipment or contract with another party, such as the manufacturer, to remarket the equipment in exchange for a remarketing fee.

Renewal Option – Option to renew the lease at the expiration of scheduled lease term.

Residual Value – The value, either actual or expected, of the leased equipment at the end of the lease.

Revenue Ruling 55-540 – In order to avoid tax abuse, the IRS issued Revenue Ruling 55-540 in 1955, which defined what was not a true lease for tax purposes, commonly referred to as a lease intended as a security. 55-540 holds a transaction not to be a true lease if any one or more of the following conditions are present:

  • Any portion of the periodic lease payment is applied to an equity position in the asset to be acquired by the lessee;
  • The lessee will automatically acquire title to the property upon payment of a specified amount of “rentals” he/she is required to make;
  • The total amount which a lessee is required to pay for a relatively short period of use constitutes an inordinately large proportion of the total sum required to be paid to secure the transfer of the title;
  • The agreed “rental” payments materially exceed the current fair rental value;
  • The property may be acquired for a nominal purchase option in relation to the value of the property at the time the option may be exercised; and
  • Some portion of the periodic payment is specifically designated as interest or its equivalent.

Running Rate – The rate of return to the lessor, or cost to the lessee, in a lease based solely upon the initial equipment cost and the periodic lease payments, without any reliance on residual value, tax benefits, deposits or fees. This rate is referred to also as the street or stream rate.

Sale-Leaseback – Transaction where one party sells its equipment to another and immediately leases it back.

Schedule A – A document, typically incorporated by reference into the lease agreement, which describes in detail the equipment being leased. The schedule may state the lease term, the commencement date, the repayment schedule and the location of the equipment.

Scheduled Lease Term – Standard fixed term of the lease exclusive of any interim periods or extension periods.

Soft Costs – Those costs that are directly attributable to an item of equipment and are necessary to bring that item of equipment into service but are not recoverable should the asset be removed and returned to the lessor at lease expiration. Examples include freight, taxes, concrete work, labor and installation.

Spread – The difference between the yield and the underlying debt cost. It is the economic margin on each lease. Spread is a constant rate of return realized from the excess of lease payments over that required to service debt.

Stated Residual – This reflect the lessee’s purchase option. It is the value of the leased equipment at the conclusion of the lease term from the lessee’s perspective. The stated residual need not be expressed in terms of a percentage or dollar amount; it can be expressed in terms of type of lease termination option such as fair market value (FMV) or no option (walk-away lease). It bears no relationship to priced residual other than a lessor generally seeks to recover at least its priced residual at lease termination, either directly from the lessee or from a third party. Certain termination options, such as fixed purchase option, have a stated fixed percentage or amount for which the lessee can buy the equipment.

Structuring – Considering the many components of a potential lease transaction, such as lease term, lessor yield, end-of-term option(s), origination fee, repayment schedule and rental payments when offering a lease to a customer.

Stipulated Loss Value – The contracted amount that the lessee is obligated to pay (or cause an insurer to pay) to the lessor in the event that the equipment is lost or irreparably damaged during the lease term. The lessee is usually also obligated to pay the stipulated loss value to the lessor in the event of a default under the lease.

Tax-Priced Lease – A lease where the lessor recognizes the tax incentives provided by the tax laws for investment and ownership of the equipment. Generally, the lease rate factor on a tax lease is reduced to reflect the lessor’s recognition of this tax incentive (tax juice).

Terminal Rental Adjustment Clause (TRAC) – A lease provision that permits or requires an adjustment of rentals at lease termination according to the amount realized by the lessor upon sale of leased equipment. A TRAC shifts the residual risk to the lessee. A TRAC lease may be treated as a “true lease” if it otherwise meets tax guidelines even though residual risk is shifted away from the lessor. A TRAC lease will be classified for financial reporting purposes as a capital lease for the lessee unless the lessor accepts enough risk through a residual sharing agreement such as an ETO to meet the 90 percent test to qualify it as an
Operating lease. TRAC leases are only available for equipment licensable for highway use.

Termination – The end of the lease term and completion of the lease.

Trade-In – The value of used equipment which is deducted from the price of new equipment by a dealer or manufacturer.

True Lease – A lease which for federal income tax purposes allows the lessor to claim the tax benefits on leased equipment because lessor has assumed risks of ownership.

UCC Financing Statement – A document used under the Uniform Commercial Code (UCC), filed with the secretary of state (and sometimes the county) to provide public notice of a security interest in personal property or fixtures.

Unamortized Lease Balance – The lessor’s economic (cash) investment remaining in each lease at any time throughout the lease term. This balance is reduced or amortized throughout the lease term as each payment is received. Part of each lease payment covers the interest accrued (at the yield rate) and part for balance reduction. It is this balance plus any accrued interest that must be paid off when terminating a lease (plus early termination charges where applicable).

Uneven Rents Test (IRS Regulation 467) – An IRS test that checks to make sure the total annual rents from each year are between 90% and 110% of the average rent. This allows for accrual of advance rents for income tax purposes. This regulation applies to contracts with total lease payments exceeding $250,000

Yield – The interest rate earned by the lessor (or equity participant) on a lease. It is measured by the excess of cash flows (including tax benefits, if any) over original investment expressed as a percentage of the weighted average lease balance. Yield is synonymous with the internal rate of return on a non-tax lease. Typically, yield is expressed in percentage terms. This means, the particular percentage is earned on the current outstanding lease balance for every period of the lease. Yield on a tax-oriented lease is similar; however, there are additional cash flows from tax savings and payments that must be considered.

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