The lessor can claim the tax deductionsassociated with asset ownership and reali

Question

The lessor can claim the tax deductionsassociated with asset ownership and realize the leasedasset’s residual value. In return, the lessor must pay tax onthe rental income.

a. Explain why a financial lease representsa secured loan in which the lender’s entire debt servicestream is taxable as ordinary income to the lessor/lender.

b. In view of this tax cost, what taxcondition must hold in order for a financial lease transaction togenerate positive net-present-value tax benefits for both thelessor and lessee?

c. Suppose the lease payments in Table 21-2must be made in advance, not arrears.

d. Show that if NACCO is nontaxable, thenet advantage to leasing is negative and greater in absolute valuethan the net advantage of the lease to the lessor.

e. Either find a lease rate that will givethe financial lease a positive net advantage for both lesser andlessee, or show that no such lease rate exists.

f. Explain what your answer to part eimplies about the tax costs and tax benefits of the financial leasewhen lease payments are made in advance.

Explanation / Answer

A lease represents a form of secured debt. Eachlease payment includes an interest

component and a principal repayment component. Because the lease payment is

taxable as ordinary income to the lessor,in

effect, the entire debt service stream (i.e., theinterest component and the principal

component) is taxable as ordinary income.

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