To Lease or Buy: One of the Tougher Questions we Face

The question that I am most confronted with when talking cars and finance is whether it is best to lease or buy. Unfortunately, there is no simple answer. My normal response is "Well that depends." which is usually followed by "What kind of financial consultant are you?"

The reality is that each buyer's circumstances, needs and desires are different. If I've heard it once, I've heard it a hundred times: "leasing is better because you can write it off." Never has such a misguided statement been repeated by so many. First, you can only deduct from taxable income, expenses incurred to earn that income. The specific expenses that may be deducted are contained in Section 8 of the Income Tax Act (ITA) and include expenses associated with leasing or purchasing an automobile.

Generally, one can deduct automobile expenses when their situation is as follows:

1. they are self-employed and use an automobile to travel as a part of their work or;
2. they required by their employer to supply and use an automobile in the course of business.

If either of these circumstances applies, the expenses associated with the use of an automobile that are reasonable, are deductible for tax purposes. Those expenses could include actual leasing costs or interest and capital cost allowance (CCA) where the taxpayer has purchased. Both are effectively meant to provide tax relief for the use of capital associated with an automobile. What do we mean by this? It is the principal component of the automobile, which is depreciated over time, and the opportunity costs of tying up cash in the car.

Basically, leasing is a means in which to finance a capital asset such as an automobile. Leasing costs typically include a principal component associated with the depreciation and interests costs to compensate the lessor for the funds that they have used to facilitate the transaction. Effectively, this is similar to borrowing the funds and paying back the principal over a specified term. The major difference is this. When you borrow the money, you pay back ALL of the principal and the associated interest cost over the term of the loan. In the case of a lease, you only pay back a portion of the principal plus the associated interest costs. The amount of principal paid should and will typically be correlated to the depreciation of the automobile.

The major advantages to leasing are twofold. First, you are paying only for the portion of the automobile that you are using which may lower your monthly outlay. Secondly, if you plan on disposing of the car before the end of its useful life, you probably will pay less in sales tax, which is effectively an unrecoverable expense when you purchase.

Let us consider an example. Let us say that Rob is going to either purchase or lease a car costing $30,000. He can borrow the money from a bank @ prime + 2% (currently 6%) or he can lease it from ABC Leasing who will charge 7% interest on the transaction.

If Rob purchases the car, he will need to borrow $34,500 ($30,000 + GST + PST). Let us also say that Rob would pay the car off over a four-year term. His monthly payments will thus be $810 and his car will be fully paid off after four years.

Alternatively, he can lease the car for four years with a $15,000 buyback. A buyback is what you can (in some leases must) pay for the car after the four-year lease term. The lease payment reflects a payment of principle and interest on the $15,000 of depreciated value ($30,000 - $15,000 buyback value) plus the interest on the $15,000 outstanding principal (the buyback value). The GST and PST are not added to the value of the automobile but are added to the actual lease payments. Thus, the total lease payment is $514 ($447 + GST + PST). But remember, at the end of four years Rob will have to pay the buyback value plus taxes ($17,250). This is summarized as follows:

Considering the above scenario, one would conclude that Rob is better off if he buys the car than he would be if he leases it. But let us also consider the disposal of the car after four years. If he purchases the car, Rob has an asset to sell and can recover $15,000. With the lease, the car would normally be turned back to the lessor.

The difference in costs is actually much less than it may seem at first. If Rob disposes of the car after two years, it may actually be more favourable for him to lease barring any penalties. The main reason that leasing may be more beneficial is simply that when you purchase, you pay the sales tax on the full value of the automobile, which can never be recovered. With a lease, despite paying added sales tax on interest, one only pays the sales tax on the depreciation of the car while it is in their possession. A mitigating factor to the tax on interest argument is the fact that in the purchase / borrow scenario, one is paying interest on the tax.

Obviously cash flow and your household budget are also an important factor. You may want to drive a $30,000 car but your budget can only support payments of $500 / month. In Rob's case he could either borrow the money to buy an $18,000 car or lease the $30,000 car. Leasing options can lower your monthly payments and allow you to drive a more expensive car with the same budget limitations. Just remember though, that unlike when you buy the $18,000 car, you will not typically build any personal equity in the lease.

Let us now turn to the income tax considerations for the leasing vs. buying with respect to Section 8 deductions. Ignoring the complexity of purchase or lease limitations and disposal rules effecting Class 10 vs. Class 10.1 assets (average vs. luxury cars), we can assess the tax impact of the leasing vs. buying decision.

Canada Customs and Revenue Agency (CCRA) permits 30% CCA (depreciation) to be expensed on automobiles. There is a special provision that basically reduces this to 15% in the year of acquisition and in the year of disposal. So let us turn back to our example and consider Rob once again, an employee of XYZ Inc., who is required by his employer to use his automobile in the course of his work.

Rob has his eye on a new Pontiac Gran Prix, which he can either purchase for $30,000 plus taxes or lease for $447.00 month plus taxes. If he purchases the car, his payments over 4 years will be $810.00 / month or a total obligation of $38,880. This obligation includes $4,330 of interest. It is Oct 1^st, 2003 and Rob plans to hold the car for four years. He travels approximately 24,000 km per year of which 18,000 km (75%) is related to his employment.

As you can see from this example, there may not be any tax advantages for Rob to lease the Gran Prix given the deal and his situation. Let's say Rob wanted a $40,000 BMW instead of the $30,000 Gran Prix. Class 10.1 automobiles (generally automobiles costing more than $34,000 MSRP) are not subject to capital recapture, which provides further rationale for purchasing.

You may be starting to appreciate that there are many considerations when making the decision to lease or buy an automobile including:

• The deal itself (purchase price, interest rates etc.);
• How long you plan to keep the car;
• The deductibility of expenses under Section 8 of the ITA?
• The value of the car (MSRP);
• Your business use (%);
• Your total expected use (kms);
• Your marginal tax bracket;
• Your budget;
• Your personal desires (automobiles are an emotional decision).

So the next time I am asked whether it is better to lease or buy, you will have to excuse me for my seemingly uniformed answer: "Well that depends."

[1] CCA ($) = $0 due to Sale Proceeds exceeding Undepreciated Costs
[2] Deductible Costs = [CCA ($) + Interest] x 75%
[3] Deductible Costs = Total Payments x 75%