Leasing energy-related improvements, especially the use of tax exempt lease-purchase agreements for energy efficient-equipment, is a common and cost-effective way for state and local governments (as well as commercial property owners) to finance upgrades and then use the energy savings to pay for the financing cost. Leases often have slightly higher rates than bond financing. However, leases are a faster and more flexible tool than many other options, including bond financing, and are an important tool for public entities to finance improvements in their own buildings.
Leases are contracts that allow an entity to obtain the use of (or to purchase) equipment or real estate. They are similar to long term rental agreements where the lessee uses the equipment for a period of time in return for regular payments to a third party (lessor). Leases come with a purchase option that can be exercised at the end of the lease period.
Tax-Exempt Lease-Purchase Agreement
The most commonly used lease arrangement by state and local governments is a tax-exempt lease-purchase agreement, which is an effective alternative to traditional debt financing (bonds, loans, etc.) because it allows a public organization to pay for energy upgrades by using money that is already set aside in its annual utility budget. When properly structured, this type of financing makes it possible for public sector agencies to draw on dollars to be saved in future utility bills to pay for new, energy-efficient equipment and related services today.
A tax-exempt lease-purchase agreement, also known as a municipal lease, presumes that the public sector organization will own the assets after the lease term expires. Further, the interest rates are appreciably lower than those on a taxable commercial lease-purchase agreement because the interest paid is exempt from federal income tax for public sector organizations. Although the financing terms for lease-purchase agreements may extend as long as 15 to 20 years, they are usually shorter than 12 years and are limited by the useful life of the equipment.
Key Leasing Terms
Lease arrangements have a complex set of language to define financial, tax, and legal implications. A few key terms for tax-exempt lease-purchase agreements:
- Lease-purchase versus true lease: In a lease-purchase transaction (also called a finance lease or an installment lease) the title to the equipment is granted to the state or local government when the lease is signed. In a true lease transaction, the lessor holds the title until the lease matures.
- Tax exempt versus commercial lease: A tax-exempt lease gives the title to a tax-exempt entity (such as a school), which means the interest paid is exempt from federal income tax. With a commercial lease the title is held by a commercial entity, and the interest paid is taxed. Commercial leasing can be a cost-effective financing vehicle for energy efficiency and renewable energy equipment that is subject to receiving substantial tax incentives. This is because the tax credits are able to be claimed by the lessor instead of the state or local government (which does not pay taxes).
Procuring Lease Financing
There are two major methods of procuring lease financing:
- Private-Placement Agreements (or Single Investor Leases): One investor, such as a commercial bank, leasing company, or pension fund provides the capital. These leases are attractive for smaller projects, but may be appropriate for larger projects as well. Interest rates are lower on larger transactions because the origination costs are spread over a larger financed amount.
- Certificates of Participation (COPs): COPs are a tool for obtaining financing from multiple investors. COPs give investors a fractional interest in one or more underlying leases; lease payments are passed through to investors based on the fraction of the outstanding COPs they own and the COPs are ultimately secured by the equipment or real estate that secures the underlying lease. Because they are more liquid (i.e., easy to sell to other investors) and spread default risk across more investors, they typically attract a broader investor base and more competitive terms than privately placed leases. However, there are fixed costs involved in issuing COPs, so they may be cost-prohibitive for small or one-off projects.
In addition, master leases, which can be private placements or use COPs, are similar to a line of credit and can allow lessees to add equipment with varying useful lives to existing leases. The primary advantage is reduced paperwork and approval time. Today, however, master leases are used less because of lender's unwillingness to set pricing due to financial market uncertainties.
Please note: Lease treatment varies in different states. Consult with your tax or financial advisor to understand which laws and restrictions apply in your region.
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- Washington Lease Purchase Case Study.