What is Prepaid Lease?
A prepaid lease is a technique used to structure tangible assets, which include plant, equipment, and real estate. The structure typically includes the prepayment of a lease for use of assets over the long term. The one leasing the asset receives the option to buy 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 is intended for long-term use, the prepaid lease can reduce the present value of the tax liability of the seller 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. This 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. It cannot be a bargain option.
Benefits and Considerations of Prepaid Lease
There are several benefits from a prepaid lease. Sellers 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 buyer cannot get legal title to the specific asset until the lease expires. 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 a prepaid lease is that the buyer may be subjected to the bankruptcy risk of the seller.
Thank you for reading CFI’s guide to prepaid leases. To learn more, see the following CFI resources: