There are two ways in which a lease can be treated for tax purposes: as a true lease or as a form of financing. If the lease is viewed as a true lease, the lessee is entitled to a deduction, in the appropriate period, for his annual rental expenses. (Normally, the appropriate period is the period in which the liability for rent is incurred, in accordance with the terms of the lease, granted that the timing of the liability is not unreasonable.) If the lease is viewed as a form of financing, the lessee is deemed the property's equitable owner and is thus permitted to deduct the depreciation and interest expense.
The test the IRS applies to determine whether a lease is a true lease or a form of financing is basically an evaluation of the purchase options. If the lessee can purchase the property for less than the fair market value or for an amount approximately equal to what the debt balance would have been had the asset been bought outright, the transaction is viewed as a financing agreement. If the lessee has a purchase option in an amount substantially exceeding the probable fair market value or the debt balance, the transaction would probably be recognized as a lease.