A prepaid lease is a technique used to structure the tangible assets which include equipment, plant and real estate. The structure basically includes prepaid lease of the assets in the long term. They are sold and the buyer has the option as to whether to get the asset right after the lease term finally ends. The seller can get about 80 or even 90% of the fair value of the said asset if there is an up-front rent payment made. If the asset has a long term use, the prepaid lease can reduce the present value of the tax liability of the seller by about 50%.
There are core requirements for a prepaid lease. First is the lease term. It should not go beyond 80% of the remaining life of the asset. The next requirement is the residual value which is the estimated fair value of the asset when the lease term ends. This value should be 20% of the original cost of the said asset. The last requirement is the purchase option. If the buyer wishes to purchase the asset, it has to be within the reasonable amount. It cannot be a bargain option.
There are several benefits with prepaid lease. Sellers can get up to about 80 to 90% of the fair value of the asset. There is also a wide range of assets that are eligible for prepaid lease. For instance, assets that have long term useful life can be maximized. On top of that, the rental income can also be amortized over the term of the lease.
In as much as there are benefits, there are also considerations. For example, a buyer cannot get legal title to the specific asset. The buyer may also want to weigh the value to see the difference between the value of deductions in the rental and the tax depreciation. Another key issue with prepaid lease is that the buyer may be subjected to the bankruptcy risk of the seller.