The kind of property leased isn't relevant. Any kind of real or personal property could have either kind of lease.
A lease intended as security will allocate few, if any, obligations (e.g. repair and maintenance, control, insurance, risk of loss) to the lesssor-lender, and will have a term such that the price to purchase the remainder interest in the property at the end of the lease term is minimal. While no one fact is dispositive and each case has to be resolved individually, the amount of the remainder interest and the likelihood that the tenant will eventually own the property or will use it for its entire economic life is the most important factor.
One of the main sources of law for distinguishing between the two is section 203 of Article 1 of the Uniform Commercial Code which states:
§ 1-203. Lease Distinguished from Security Interest.
(a) Whether a transaction in the form of a lease creates a lease or
security interest is determined by the facts of each case.
(b) A transaction in the form of a lease creates a security interest
if the consideration that the lessee is to pay the lessor for the
right to possession and use of the goods is an obligation for the term
of the lease and is not subject to termination by the lessee, and: (1)
the original term of the lease is equal to or greater than the
remaining economic life of the goods; (2) the lessee is bound to renew
the lease for the remaining economic life of the goods or is bound to
become the owner of the goods; (3) the lessee has an option to renew
the lease for the remaining economic life of the goods for no
additional consideration or for nominal additional consideration upon
compliance with the lease agreement; or (4) the lessee has an option
to become the owner of the goods for no additional consideration or
for nominal additional consideration upon compliance with the lease
(c) A transaction in the form of a lease does not create a security
interest merely because: (1) the present value of the consideration
the lessee is obligated to pay the lessor for the right to possession
and use of the goods is substantially equal to or is greater than the
fair market value of the goods at the time the lease is entered into;
(2) the lessee assumes risk of loss of the goods; (3) the lessee
agrees to pay, with respect to the goods, taxes, insurance, filing,
recording, or registration fees, or service or maintenance costs; (4)
the lessee has an option to renew the lease or to become the owner of
the goods; (5) the lessee has an option to renew the lease for a fixed
rent that is equal to or greater than the reasonably predictable fair
market rent for the use of the goods for the term of the renewal at
the time the option is to be performed; or (6) the lessee has an
option to become the owner of the goods for a fixed price that is
equal to or greater than the reasonably predictable fair market value
of the goods at the time the option is to be performed.
(d) Additional consideration is nominal if it is less than the
lessee's reasonably predictable cost of performing under the lease
agreement if the option is not exercised. Additional consideration is
not nominal if: (1) when the option to renew the lease is granted to
the lessee, the rent is stated to be the fair market rent for the use
of the goods for the term of the renewal determined at the time the
option is to be performed; or (2) when the option to become the owner
of the goods is granted to the lessee, the price is stated to be the
fair market value of the goods determined at the time the option is to
(e) The "remaining economic life of the goods" and "reasonably
predictable" fair market rent, fair market value, or cost of
performing under the lease agreement must be determined with reference
to the facts and circumstances at the time the transaction is entered
A recap of a case from 2006 in the United States Court of Appeals for the 7th Circuit based in Chicago, involving United Airlines, provides a detailed example. It is summarized as follows:
Prior to filing for chapter 11 protection in 2002, United Airlines
entered into a series of transactions to fund the improvement of its
facilities at four airports. One such lease arrangement involved
public financing underwritten by the California Statewide Community
Development Authority (the “Authority”). United has been the lessee
since 1973 of a 128-acre maintenance base at San Francisco
International Airport ("SFO"). The lease expires in 2013 unless the
parties negotiate an extension. Rent depends on an independent
party's estimate of the property's market value.
In 1997, the Authority issued $155 million in bonds to finance
improvements to United's SFO facilities (other than the maintenance
base). The bonds are without recourse to the Authority and are
guaranteed by United. United subleases 20 acres of the 128-acre
maintenance base to the Authority for 36 years — the term matches the
bond repayment schedule rather than United's lease with SFO. The
Authority paid $1 to sublet the premises.
The Authority leases the 20 acres back to United for rent equal to
interest on the bonds plus an administrative fee. This lease has a
$155 million balloon payment in 2033 to retire the principal. United
may postpone final payment until 2038; if it does, the sublease also
is extended. United is entitled to prepay, in which case the sublease
and leaseback terminate. If United does not pay as agreed, the
Authority can evict it from the 20 acres. The leaseback includes a
“hell or high water” clause requiring United to pay the rent even if
its lease from the SFO ends before 2033, the property is flooded, or
some other physical or legal event deprives United of the use or
economic benefit of the maintenance base.
After filing for chapter 11, United took the position that none of the
arrangements at the four airports in question is a “lease” for
purposes of section 365 of the Bankruptcy Code. Instead, United
sought a declaratory judgment that each transaction involves secured
financing and that United should have the right to continue using the
airport facilities while paying only a portion of the promised “rent.”
The bankruptcy court ruled that the arrangement at one of the airports
is a true lease, but that the other three transactions (including the
SFO arrangement) are not. The district court reversed those rulings
in part on appeal, holding that all four transactions involved true
leases rather than secured financings. United appealed to the Seventh
The Seventh Circuit's Ruling
The Seventh Circuit joined all the other circuit courts of appeal that
have considered this issue, ruling that substance rules over form and
that only a “true lease” qualifies as a “lease” under section 365 of
the Bankruptcy Code. In reaching this conclusion, the Court of
Appeals considered the practical meaning of the Bankruptcy Code, the
Uniform Commercial Code (the “UCC”) and the historical context of the
Bankruptcy Code’s enactment, including the statute's legislative
According to the Seventh Circuit, it “is unlikely that the
[Bankruptcy] Code makes big economic effects turn on the parties’
choice of language rather than the substance of their transaction,”
because to do so would allow the drafters of contracts to obliterate
the distinction between the two types of transactions through creative
drafting. This is consistent with the UCC, which, unlike the
Bankruptcy Code, contains a detailed description of the distinction
between a lease and a security interest, emphasizing that "[w]hether a
transaction creates a lease or a security interest is determined by
the facts of each case."
The Court of Appeals went on to explain that a lease in which "current
consumption" (i.e., lease payments at market rates for continued use
of an asset) dominates is often called a “true lease,” while one in
which the asset serves as security for an extension of credit is
treated as a security agreement governed by the UCC. Finally, the
Court of Appeals observed, the legal community of the 1970s understood
that the distinction between leases and security agreements was based
on substance rather than form, and looked to the relevant legislative
history from the adoption of the Bankruptcy Code, which explains, in
Whether a "lease" is [a] true or bona fide lease or, in the
alternative, a financing "lease" or a lease intended as security,
depends upon the circumstances of each case. The distinction between
a true lease and a financing transaction is based upon the economic
substance of the transaction and not, for example, upon the locus of
title, the form of the transaction or the fact that the transaction is
denominated as a "lease."
Thus, the Seventh Circuit concluded that substance, rather than form,
should be considered in determining whether a transaction is a “true
lease” or a disguised secured financing for purposes of section 365 of
the Bankruptcy Code.
The Court of Appeals then examined which law should apply to divine
the true nature of any given transaction. Explaining that "nothing in
the Bankruptcy Code says which economic features of a transaction have
what consequences," the Seventh Circuit concluded that state law is
determinative on this issue — in this case California law.
California, the Court of Appeals observed, has adopted a functional
approach to the question in both the UCC and the common law governing
real property transactions. It went on to discuss California court
rulings examining various features of lease and financing
The Seventh Circuit ultimately determined that the transaction between
United and the Authority was not a “true lease” under California law
for the following reasons: (i) the “rent” was not measured by the
market value of the property; (ii) at the conclusion of the lease, the
Authority had no residual interest; (iii) the balloon payment had no
counterpart in a true lease, but was a common feature of a secured
financing; and (iv) upon prepayment, the lease and sublease
terminated immediately, whereas in a true lease, prepayment secures
the tenant’s right to use the property for the term of the tenancy.
Based upon this conclusion, the Court of Appeals reversed the district
court's decision and remanded the case for further proceedings.
The question, in setup discussion not directly relevant to the answer states that the security interest v. lease distinction is important because if it is a security interest, rather than a lease:
[the] asset is subject to automatic stay, which prohibits recovery of
or foreclosure on collateral.
This is actually true of both security interests and leases.
The main distinction between a security interest and a lease is that debt secured by collateral may be "crammed down" (i.e. partially discharged) so that only the amount of debt equal to the value of the collateral remains in force. In contrast, if an agreement is a true lease, the debtor must either accept it and fully comply with the lease, or reject it entirely. A debtor may not "cram down" a true lease in the way that a debtor could a secured debt payable in installments, without the express consent of the lessor.
Background Insight: Why Do Businesses Enter Into Finance Leases?
Why would any debtor want a financing lease rather than a security agreement?
This is mostly income tax driven.
If you own property, you get to deduct depreciation according to an IRS formula and interest paid as it is paid. Principal payments on the loan aren't deductible. While in the long run this adds up to the total amount paid with respect to the property, it doesn't match up exactly, so sometimes, you have cash flow without income, and sometimes, you have income without cash flow. Principal payments attributable to land value can never be deducted as an expense by a business (which is why many commercial buildings are built on land that they lease from non-profits so that the business, which can't deduct the land value expense if it owns the land, can deduct the land value expense since it is a lease payment; the non-profit only cares about cash flow and doesn't need the depreciation deduction because it doesn't pay income taxes).
If you lease property, you get a deduction for the full amount of the lease payment, when paid, so cash flow always exactly matches your tax deductions for the property.
Section 179 and accelerated depreciation for tangible personal property, especially the kind with a fairly short useful life, favor buying rather than leasing smaller purchases. But, in the case of very expensive business assets (especially for big businesses) and in the case of real estate, it is usually more favorable from a tax perspective for a business to lease an asset than to buy it.