What is a municipal or tax-exempt lease?

A municipal or tax-exempt lease agreement allows a political subdivision to use annual revenues to make payments for any type of essential use equipment or facilities. This financing method is a popular alternative to purchasing an asset with cash, using an operating lease, or issuing bonds.

The 'tax-exempt' or 'municipal lease' qualification to this financing method is associated with the federal income tax exemption recognized by the lessor on the interest earnings they receive through the repayment schedule. The same tax laws enabling 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 financing 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).