A municipal or tax-exempt lease agreement allows a political subdivision to use its annual revenues to make payments for any type of essential use equipment or facilities. This structure is an alternative to purchasing an asset with cash, acquiring its use for a period of time through a true lease, or issuing bonds.
The term ‘tax-exempt’ or ‘municipal lease’ refers to the interest earnings paid to the lessor of a properly structured and documented lease, being exempt from federal income tax. The same tax laws that enable a municipal bond to carry a tax-exempt rate apply to a municipal lease. Only municipalities or qualified political subdivisions can qualify for this type of agreement. Because the lessor does not pay federal income tax on the interest earned, the tax-exempt lease carries a much lower interest rate than other types of leases and installment loans. This significantly lowers the cost of financing to the borrower.
While municipal leases are documented as a lease, they have characteristics similar to a loan. The lessee owns the equipment at the end of the lease, and the lease can be paid-off early. These financing agreements are structured as a lease to accommodate the fiscal funding restrictions of political subdivisions. In most cases, the obligation terminates if the lessee fails to appropriate funds to make the renewal year’s lease payments. Because of this provision, neither the lease nor the lease payments are considered debt (in most states).