What is a tax-exempt lease?
Let us start by making clear what a tax-exempt lease is not. A tax-exempt lease is not a true lease or an operating lease. Tax-exempt does not refer to the fact that the lessee is exempt from taxes (as most government entities are) but refers to the federal tax treatment of the interest component of the lease payments made by the government. As further discussed in question 4, the use of lease terminology is confusing because a tax-exempt lease has to comply with both federal law and state law. Federal law provides that in order for the lease to be tax-exempt the government has to have incurred a debt. (In order for there to be an interest component there has to be a principal component.). In other words, the tax-exempt lease is really a disguised sale or loan and is both economically and accounting-wise the equivalent of a conditional sales contract. State constitutions and statutes, on the other hand, impose significant restrictions on government entities ability to incur debt. Thus
A tax-exempt lease is a financing transaction in which: (a) The lessee is a state or any political subdivision (e.g., a state agency, county government, city or municipal government, school district, etc.), any possession of the United States, or the District of Columbia; (b) The interest component of payments made is excludable from the lessor’s gross income for federal income purposes; and (c) “Debt” is not created for state law purposes. It is not intended to be, nor is it, a true lease or an operating lease. Though the documents for these transactions are often labeled “lease-purchase agreements” and employ traditional lease language (e.g., lessor, lessee, rent, etc.), the transaction structure is comparable to that of a conditional-sales contract or a lease-purchase. The obligation must be structured as a purchase by the lessee for federal tax purposes (i.e., “debt”). The transaction must be structured as an installment sale with a nominal purchase option (i.e., no more than 5%).
