What is a Prepaid Lease?
A prepaid lease (or operating lease) is a contract to acquire the use of tangible assets, which include plant, equipment, and real estate. The transaction typically includes the contractual obligation to use the assets over the long term.
The party leasing the asset (lessee) is often provided with an option to buy the asset right after the lease term finally ends. The lessor can typically get about 80% or even 90% of the fair value of the leased asset if there is an up-front rent payment made. If the asset is intended for long-term use, the prepaid lease can reduce the present value of the tax liability of the lessor by about 50%.
What are the Core Requirements?
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. The residual value should be 20% of the original cost of the asset.
The last requirement is the purchase option. If the lessee wishes to purchase the asset, it must be for a reasonable amount. There cannot be a bargain purchase option. If these requirements are not met, then the lease will be considered a capital lease and is treated differently for accounting purposes.
Benefits and Considerations of Prepaid Lease
There are several benefits from utilizing a prepaid lease. Lessors can get up to about 80% to 90% of the fair value of the asset. The value of 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 lessee does not get legal title to the specific asset unless the option to purchase is exercised at the end of the lease. The lessee 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 a prepaid lease is that the lessee is subjected to the risk that the lessor will go bankrupt.
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