Close the skill gap with the Financial Modeling & Valuation Analyst (FMVA)® Certification >> Enroll today and save!

Prepaid Lease

The prepayment of a lease for the long-term use of certain assets

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 assets are sold and the buyer receives 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 is intended for long-term use, the prepaid lease can reduce the present value of the tax liability of the seller by about 50%.

 

Prepaid Lease

 

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 said asset. The last requirement is the purchase option. If the buyer wishes to purchase the asset, it must be within the 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. There is also a wide range of assets that are eligible for a 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 a prepaid lease is that the buyer may be subjected to the bankruptcy risk of the seller.

 

Other Readings

Thank you for reading CFI’s guide to prepaid leases. To learn more, see the following resources:

  • Income statement
  • Balance sheet
  • Current Ratio
  • Projecting Balance Sheet Items

Free Accounting Courses

Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes.
These courses will give the confidence you need to perform world-class financial analyst work. Start now!

 

Building confidence in your accounting skills is easy with CFI courses! Enroll now for FREE to start advancing your career!