What Is Novated Leasing and How Does It Work?

Understanding the Novated Lease Agreement

A novated lease is a financial arrangement involving three parties: an employee, their employer, and a finance company. The employer assumes the employee’s obligations under a vehicle lease contract. While the employee selects the vehicle for personal use, the employer enters a separate agreement with the finance company to cover the lease payments.

This tripartite relationship allows the employee to utilize a vehicle without being solely responsible for direct lease payments. The finance company holds ownership of the vehicle throughout the lease term, while the employee is the primary user. The employer’s involvement transforms the traditional two-party lease into a three-party agreement, creating a distinct financial and administrative pathway for vehicle access. The employer is responsible for ensuring lease payments are made, often through deductions from the employee’s salary. This arrangement distinguishes a novated lease from a standard personal vehicle lease.

Financial Flow and Included Costs

Vehicle-related expenses in a novated lease are managed through an employee’s compensation. When an employer facilitates payments for a vehicle, these amounts are generally treated under US tax law as a non-cash fringe benefit to the employee. This means the value of the personal use of the vehicle typically becomes part of the employee’s taxable income.

Employers have specific methods to value an employee’s personal use of a company-provided vehicle for tax purposes, as outlined by the Internal Revenue Service (IRS). One common method is the Annual Lease Value (ALV) method, which uses a table provided by the IRS to determine the value based on the vehicle’s fair market value when it is first made available. Another option is the Cents-Per-Mile method, where the value is calculated by multiplying the employee’s personal miles by the IRS standard mileage rate, which was 70 cents per mile for 2025.

The standard mileage rate generally covers the costs of fuel, maintenance, and insurance. If the employer provides fuel separately, its value must be included in the employee’s income at fair market value. For employers, the lease payments and associated vehicle costs are typically deductible business expenses.

The value of the personal use, determined by one of these methods, is added to the employee’s wages and reported on their Form W-2. This imputed income is subject to federal income tax, Social Security, and Medicare taxes. Employers are responsible for calculating this fringe benefit and ensuring proper tax withholding and reporting.

Employees must maintain detailed records of their business and personal mileage to substantiate vehicle use. This record-keeping is important for both the employee and employer to accurately assess and report the taxable benefit.

Vehicle Ownership and End-of-Lease Options

During a novated lease, the finance company retains legal ownership of the vehicle; the employee has exclusive use but does not hold title. The lease agreement specifies a duration, typically two to five years, at the end of which various options become available.

The residual value, also known as the balloon payment, is the estimated wholesale value of the vehicle at the conclusion of the lease term, determined by the lessor at the lease’s inception. This value is a significant factor in calculating the monthly lease payments, as payments primarily cover the vehicle’s depreciation.

At the lease’s conclusion, the employee typically has several choices regarding the vehicle. One common option is to purchase the vehicle outright by paying the predetermined residual value to the finance company, transferring ownership to the employee.

Alternatively, the employee can choose to re-lease the existing vehicle under a new novated lease agreement. This involves negotiating new terms, including a new lease period and potentially a revised residual value. A third common option is to trade in the vehicle and initiate a new novated lease for a different car, allowing the employee to upgrade to a newer model while maintaining the benefits of the novated lease structure.

In some scenarios, if the lease terms permit, the employee may simply return the vehicle to the finance company. The choice among these options depends on the employee’s financial situation, vehicle needs, and the specific terms of their lease agreement.