Lease or Buy a Car? Check Your Cash, Taxes, Circumstances

You’ve been eyeing the gleaming yellow Mercury Cougar in the showroom of that car dealership you drive past every night. You know you need a new car, but the Cougar costs $15,000. That means you probably need a $3,000 down payment just to qualify, and your old clunker isn’t worth that much as a trade-in.

The sharp rise in new car prices in the last few years has put more and more motorists into this position: They can afford the payments on the car they want, but can’t come up with the 20% down payment typically needed to buy it. (Some lenders are now offering purchase loans up to 100% on new cars, but the industry standard has been 80%.)

This common dilemma has led to a boom in the car-leasing business, perhaps the most popular method of buying a car with no money down. As much as 40% of the car “sales” at some dealerships are a lease rather than an outright purchase. And now banks have come up with a new twist on the conventional auto loan, offering financing with no money down that is structured like a lease and has a “balloon” payment due at the end of the contract.

In some cases, leasing or taking out such a loan can be a better deal than buying the car with the conventional 20% down. But figuring out which is the most economical can be difficult, especially if you sometimes use the car for business. And recent changes in the tax laws have muddied the numbers even further, to the point that even some tax accountants are a bit confused.

One thing is clear: If you have the cash or a trade-in, buying the car with a 20% down payment is the cheapest way to go--provided you use the car exclusively for personal affairs. The monthly payments will be higher with the straight purchase, but after taking everything into account, owning a car is cheaper than leasing one, and the gap between the two widens as the price of the car goes up.

“I always tell my clients that it’s better to buy,” says Michael Sedgwick, a tax specialist with the Century City office of Ernst & Whinney, a major accounting firm. “In a straight lease situation, you’re borrowing more money so it’s more expensive.”

However, if you can deduct all or part of the costs of ownership against your income taxes because you use the car for business, the best deal is not as obvious. Owning is cheaper than leasing for less-expensive cars, but for a $40,000 vehicle, you might be better off with a lease than a purchase under the new tax laws.

Your tax savings will depend on how well you can document your business use. Beginning this year, Internal Revenue Service regulations require car owners to keep a detailed mileage log of business trips. Thus, business-use deductions may be more difficult to take.

If you have no down payment, there are distinct advantages to the new bank-loan programs that allow you to buy with no cash and then have a balloon payment due at the end of the loan term, typically four years. These loans are structured very much like a lease, but you get the advantage of being able to deduct the interest you pay on the loan from your income taxes--something you can’t do with a lease--and if you use the car for business, you can lower your income taxes with depreciation and other tax provisions.

There are also advantages to a lease. You don’t own the car, and thus don’t have to worry about selling it or trading it in when you want to buy a new one. You simply give it back to the owner and walk away.

And the monthly lease payments can be well below what it would cost to buy the vehicle, partly because of tax benefits the leasing company gets. Tax law changes in 1981 created an incentive for auto manufacturers, banks and others to go into the business of leasing cars to others. The owner of the car, in this case the leasing company, gets tax credits and depreciation benefits as well as profit from the actual lease payments from the customer.

Thus, leasing companies and car dealers are often willing to lease cars for less than a customer would pay for a bank loan to buy the car. The current charges at some dealerships are equivalent to 11% financing.

But persuading a typical car buyer to lease is not easy. Sam Goldman, president of Executive Car Leasing, the largest leasing firm in Southern California, says many people are locked in to the idea that they must own their cars.

“A lot of people still don’t even like to buy things on time,” Goldman says.

The accompanying table offers some examples to show how car buyers might fare under different circumstances. It breaks down the figures into the cost per mile, based on driving 12,500 miles a year during four years of ownership. Tax accountants at Ernst & Whinney who assisted in the preparation of this article say it is difficult to generalize about the possible tax savings of owning a car used in business because of the variety of tax benefits available to different individuals. Thus, the comparisons serve more to show the differences between the ways of paying for a car rather than to indicate how much an individual might save on his income taxes.

The figures in the table are based on the following assumptions:

- The cars will be worth half their purchase price after four years.

- Lease and balloon-payment loan customers had the cash needed for a down payment to buy the car and instead invested it with a 10% annual rate of return. They also invested in the same account the savings that resulted from the lower monthly lease payment versus a purchase loan payment. They paid taxes on the interest at their personal income-tax rate.

- Buyers in the business category used the cars 100% for business purposes, which is unusual. Accountants say 70% business use is a more typical figure.

- The new limitations on investment-tax credit and accelerated depreciation were applied to the business customers.

- When the business buyers sold the cars at the end of four years, they paid income taxes on the proceeds at their personal income-tax rate.

- The table doesn’t take into account savings on California state income taxes. However, because the savings would be proportional, state taxes would have little effect on the relative difference between the methods.

- The cost per mile is a calculation of the net cost of acquiring the cars divided by 50,000 miles driven over the four years of the loan or lease.

As the table shows, the lowest monthly payments are with a lease. The payments are based on the price of the car and the lease company’s cost of borrowing, which is assumed to be 14% in the table. They would be less if the lease company figures your payments on a lower cost of borrowing.

But for personal use, the lowest cost of ownership is with a conventional purchase, even though the monthly payments are the highest. Only with the $40,000 car used in business does leasing offer an advantage for personal use, and a tremendous one at that. This is because the 1984 tax changes designed to prevent businesses from writing off the cost of luxury cars had a far greater effect on buyers than on lessors.

Of course, there are some non-financial advantages and disadvantages to both buying and leasing. If you buy a car, you can move to Michigan or Florida and take it with you without any hassle. A leased car is owned by the leasing firm, and moving away--although it can be arranged--might be more difficult.

But on the other hand, after four years, the car you buy will be needing new tires, a new battery and other parts that tend to wear out in the first 50,000 miles. The thought that your car is “finally paid off” can lead to keeping it a few more years and having these and other repair bills while the vehicle continues to lose value. About the time a leased car begins to show its wear, you simply turn it in and get a new one. You’ll always have car “payments,” but you’ll rarely have to worry about repairs or shopping for new tires.

Here’s a summary of the various ways of buying a new car, examining the financial and tax implications of each:

CONVENTIONAL LOAN--Banks, savings and loans and credit unions traditionally require a buyer to put 20% toward the purchase price of a new car for two reasons. A substantial down payment is a sign of the buyer’s financial strength and commitment to taking care of the vehicle. And because the car declines in value so rapidly in the first year, a bank loan for only 80% of the vehicle’s purchase price will ensure that the institution can get most of its money back if the car is repossessed and sold due to buyer default.

With a purchase, you pay full principal and interest on the loan and have the car fully paid off at the end of the loan term. You can deduct the interest you pay on the loan from your income for tax purposes. On a $12,000 car financed with a 14% loan, the interest over four years will be about $3,235, while the interest on a similar loan to buy a $40,000 car will be $10,784. You can also deduct the state sales tax on the purchase (6.5% in Los Angeles County, 6% in most other counties).

If you’re buying the car for business, you get to take an investment-tax credit of 6% of the purchase price up to a maximum of $1,000 for 100% business use. (If the business use is less but is at least 50%, you deduct an equivalent proportion. For instance, for 70% business use, you could take 70% of the applicable tax credit. If business use is less than 50%, you can’t take the investment-tax credit.)

You can also depreciate the vehicle over the four-year loan term in proportion to the amount of business use. The depreciation deductions are 25% of the purchase price the first year, to a maximum of $4,000; 38% the second year, to a maximum of $6,000; and 37% the third year, to a maximum of $6,000. If the car cost so much that it’s not fully depreciated after three years, you can take another deduction in the fourth year and subsequent years, to a maximum of $6,000 annually. (If business use is less than 50%, you have to use the straight-line method of depreciation, proportional to the amount of business use.)

BALLOON PAYMENT LOAN--These loans were introduced in the last year by Security Pacific National Bank and Bank of America, and may be available at other institutions. The loan is structured like a lease, but the finance charges are slightly higher at banks than you can usually get from a car dealer or a credit union for a conventional type of purchase.

You borrow the full amount from the institution, but pay back only part of it during the loan term. If the bank, using industry guide books, estimates that in four years the vehicle will be worth, say, half of what you bought it for, you have to pay off half the purchase value of the auto. Thus, for a $12,000 car, you’ll owe $6,000 at the end of the term.

You pay principal and interest on the half of the loan you are paying off, and you pay interest-only on the other half. On the $12,000 car (plus $780 in sales tax), financed at 16% for four years, you pay $192.15 a month to pay off $6,780, and you pay $80 a month as interest-only on the other $6,000, for a total monthly payment of $272.16.

You also get to deduct the sales tax and interest payments, and if the car is for business use, take the investment-tax credit and depreciation.

At the end of the term, you owe the balance of $6,000 in a single balloon payment. You have several options. If the vehicle is worth at least $6,000, you can give it to the bank and walk away, or you can sell it and repay the loan, pocketing any profit. Or you can refinance the car and keep it. If the car is worth less than $6,000, you still have to pay off the loan, and will be required to come up with some cash if you turn in the car to the bank.

At Security Pacific, you can take delivery of the car without paying a dime, but the bank charges a fee of $250 if you turn in the car to the institution. Bank of America charges an initial loan fee equivalent to 1.5% of the expected balloon payment, but charges no turn-in fee.

LEASE--Lease payments are calculated much the same way as balloon-payment loan payments, with the amount based on the leasing company’s cost of borrowing. Terms vary widely, depending on where you get your deal. You can shop for the car you want and lease it directly from the dealer or through a bank. Or you can go to a leasing company and let the agent find the car for you at the best price he can. As with a purchase, the amount you owe is based on the price negotiated for sale of the car.

There are two kinds of leases. In a “closed-end” lease, you are guaranteed to owe nothing at the end of the contract term, no matter how much the car may have depreciated beyond the original estimate. With an “open-end” lease, you could owe something, but you could also have some equity if the vehicle is worth more than the agent thought it would be when the papers were first signed.

Leases typically require you to pay license fees as well as the first month’s lease payment in advance, and some firms also may require the last month’s payment in advance. In addition, most leasing companies charge a fee at the end of the lease that can range from $200 to $350 to cover the cost of preparing the car for sale.

The sales tax you pay is calculated on the monthly payment, rather than being added to the initial selling price. You can deduct the sales tax from your income tax. However, even though most of your lease payment covers the interest paid on funds borrowed by the leasing company, you can’t deduct the interest from your taxes because you aren’t buying the vehicle. Nor do you get the benefit of the tax credit and depreciation allowance if the car is used in business.

However, you can deduct the entire lease payment from your taxes if the car is used exclusively in business, and a proportional amount if business use is less than 100%. For cars costing more than $16,500, you have to make some adjustment on your tax return that was designed to make leasing comparable to buying for tax purposes. But the adjustment has only a minor effect, which makes leasing an expensive car used in business a better deal than buying one.

A Comparison of Leasing Versus Buying a Car $12,000 car for a person in the 25% tax bracket

Buy with 20% Buy with balloon down (14 % payment (16% financing) financing) Monthly payment $283.65 $272.16 Total paid $16,015 $13,063 Tax savings, 100% personal use $1,004 $1,766 Cost per mile 18.0 cents 20.8 cents Tax savings, 100% business use $3,224 $3,986 Cost per mile 13.6 cents 16.4 cents

Lease (14% financing) Monthly payment $249.17 Total paid $11,960 Tax savings, 100% personal use $182 Cost per mile 21.6 cents Tax savings, 100% business use $2,989 Cost per mile 16.0 cents

$20,000 car for a person in the 35% tax bracket

Buy with 20% Buy with balloon down (14 % payment (16% financing) financing) Monthly payment $472.76 $453.59 Total paid $26,692 $21,772 Tax savings, 100% personal use $2,342 $4,120 Cost per mile 28.7 cents 33.9 cents Tax savings, 100% business use $6,842 $8,620 Cost per mile 19.7 cents 24.9 cents

Lease (14% financing) Monthly payment $415.29 Total paid $19,934 Tax savings, 100% personal use $426 Cost per mile 36.2 cents Tax savings, 100% business use $6,701 Cost per mile 23.6 cents

$40,000 car for a person in the 50% tax bracket

Buy with 20% Buy with balloon down (14 % payment (16% financing) financing) Monthly payment $945.50 $907.15 Total paid $53,384 $43,544 Tax savings, 100% personal use $6,692 $11,772 Cost per mile 53.4 cents 59.6 cents Tax savings, 100% business use $8,692 $13,772 Cost per mile 49.4 cents 55.6 cents

Lease (14% financing) Monthly payment $830.55 Total paid $39,867 Tax savings, 100% personal use $1,217 Cost per mile 73.0 cents Tax savings, 100% business use $14,331 Cost per mile 41.9 cents