Please Note: If you are renting or leasing vehicles, machinery, heavy-duty equipment, or lodging, then this blog post is not for you. If you are in a rent-to-own relationship, or a capital lease relationship, this blog post may also not apply.

Where Do Rental Companies Owe Sales Tax?

One nasty side-effect of renting tangible personal property is that since the title of ownership is not transferred (meaning, the rental company still owns the property), having the property in another state creates sales tax nexus there. This means that if you are renting out property to other states, then you instantly have a sales tax collection responsibility there. Sales tax “nexus” is just a technical term that means you have crossed some sort of “invisible line” and therefore have a sales tax collection responsibility in that state.

This creates a real challenge for any products that are easily movable, especially in states like Colorado that have home-rule taxation requirements. Also keep in mind that having property in other states could also create income tax nexus, and potentially create a property tax obligation, depending on what is being rented out. 

So if you rent products out to customers to other states, you could very well have a sales tax collection responsibility in just about every state in the United States. Yikes!

What Technically Constitutes a Rental or Lease of Property for Sales Tax Purposes?

When we talk about rentals and leases in the context of sales tax, the terms can generally be used interchangeably. A lease or rental occurs any time there is a transfer of possession without a transfer of ownership. For example, if I rent you a VHS tape (I promise I’m not that old) I am giving you possession of the tape, however, I, as the lessor, maintain ownership of the tape. 

Within each rental transaction, there are at least two parties: the lessor and the lessee. The lessor maintains ownership of the item and temporarily transfers possession of the item to the lessee. The lessee pays the lessor a periodic payment for the right to enjoy use of the product. 

With an operating lease agreement, at the end of the rental period the property is returned to the lessor. The lessee may have an ability to purchase for the fair market value of the property, however, it is not a rent-to-own situation. This distinction is important because sales tax is handled differently in rent-to-own scenarios.

How Is Sales Tax Paid on Rentals or Leases of Tangible Personal Property?

In brief, sales tax is typically due on the rental stream (the rental payments) of products or property. This is because most states have included rentals or leases within the definition of what constitutes a “sale”. But even if states do not take rental streams, then the initial purchase of the rental item would be subject to sales tax. So speaking in broad terms here, tax is going to be paid, one way or another, at some point during the rental of the product. The issue here is when that occurs. 

In almost every state, the periodic payments that the lessor charges the lessee are subject to sales and use tax. However, some states have given lessors the option to pay sales tax on the purchase of the property up-front, which waives their requirement to collect sales and use tax on the periodic payments from the lessee. 

For some businesses, it will be advantageous to pay sales tax on the initial purchase price of the product. For other businesses, it will be more prudential to not pay the tax up-front, and instead collect and remit sales tax from customers. 

If you, as the lessor, decide that you would rather collect and remit sales tax from your rental customers, then you can use an exemption certificate to purchase the inventory tax-free from your suppliers. But if you decide that you want to pay the tax up-front, then you cannot use an exemption certificate.

Yes, but where does the transaction occur for sales tax purposes? Is it where the customer uses the product, or where they pick it up?

With rentals, sales tax is typically collected and remitted based on where the transfer of property occurs. If you ship the product to another state, for example, then the state where the item is transferred to is where sales tax is due. If, however, the customer picks up the property at one location and then transports it to another location, then that can impact which tax authority should be paid. All Streamlined Sales Tax (SST) member states have indicated that if a product is picked up in one state and then transported to another state, then the initial rental payment’s sales tax will be due in the first state, and the rest of the rental payment’s sales tax will be due in subsequent states.

How Do Ancillary Charges (like Insurance and Maintenance Charges) Impact Sales Tax on Rentals?

Ancillary charges such as finance charges, insurance, and maintenance charges play a role as well. What’s important is trying to determine if these ancillary charges are included in the rental of the property, or if they are separately stated. If they are included with the rental of the property, they will usually be subject to sales and use tax. If they are separately stated, they have a better chance of being exempt from sales tax.

Another factor here is if the ancillary charges are mandatory. Mandatory charges are more likely to be subject to sales tax, while optional charges aren’t. We would need to look at copies of the rental agreement and invoices, as well as examine specific state statutes, to make a determination on which charges would be subject to tax.

Practical Sales Tax Audit Tips for Rental Companies

Know which states your inventory is located at all times. Since your company has sales tax nexus (owes sales tax) in any state where your rental property is located, you need to be particularly careful if your property will move across state lines. This is particularly important for anything easily transportable like machinery and vehicles. You might consider adding something to your rental agreement that states that the rented property can only be used or possessed in the original state it was rented in. 

Be mindful of how long you keep records/invoices. Even if a state’s sales tax audit lookback period is only 3 years, you may need to have copies of invoices that are older than that. This could happen if you have open rental agreements that started before the audit lookback threshold. You should always keep original purchase documents on-file for the lifetime of the assets. 

Be mindful of sales tax rate changes. If you are leasing property and the sales tax rate changes, your existing contract will likely be able to use the old rate under a “grandfather” provision. However, if you modify the contract, you may need to begin using the new sales tax rate.

Where are Rentals and Leases Subject to Sales Tax?

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