Prepaid Lease is a type of leasing option available for tangible assets like property, plants, and equipment. The structure of this lease involves the leasing of an asset for the long term and for which there is a pre-payment of the lease amount. The lessee (the party which is taking the asset on lease) gets the option to buy the asset at the end of the lease term. In this way, the seller can receive 80-90% of the fair value of his asset (through the pre-payment of the lease amount), which he has now sold to the lessee. Also, since the asset has been given on a lease, the lessor (seller of the asset) can amortize the lease payment into income over the lease term.
Hence, a prepaid lease is a tax-efficient way to sell long-term assets. Also, for assets with a long economic useful life, a prepaid long-term lease can cut the present value of the lessors’ tax liability by as much as 50%.
- Every asset has its life. E.g., a laptop may have a life of 4 years, a piece of machinery may have a life of 7 years, and so on. In the case of a prepaid lease, the lease term of the asset (number of years for which the asset has been given on lease) must not exceed 80% of the ‘remaining life of the asset.’
- The next requirement is regarding the residual value of the asset. An asset’s residual value is the amount that the asset is worth after the lease period ends or completes. In the context of prepaid leases, the residual value of the asset at the end of the lease term must be at least 20% of the original cost of the asset.
- Lastly, if the lessee exercises his option to purchase the asset at the end of the lease term, it must be for a reasonable amount.
Benefits of a Prepaid Lease
- The seller gets about 80% to 90% of the fair value of the asset through lease only. The amount which he gets for selling the asset at the end of the lease is another addition.
- The lesser can amortize the tax liability as income over the lease term. This way, he can fall into a lower tax bracket and save money.
- A prepaid lease helps the seller maintain consistency in the business results. In a prepaid lease, the seller converts one-time gain into periodic rental income over the lease term.
Disadvantages of a Prepaid Lease
- The lessee can not recognize the asset under his balance sheet until the lease term gets over and he chooses to buy the asset. Even though he (the lessee) has made an upfront payment, he doesn’t get to increase his asset column.
- The lessee cannot get tax benefits by recording depreciation of the asset. Asset depreciation is only for the lessor to consider since he is the owner of the asset for the whole lease term. The lessee can only record the lease rent payment as an expense in his income statement.
- Also, the lessee runs the risk of the lessor’s bankruptcy. If the lessor gets bankrupt and his assets are seized by the lenders, the buyer may risk losing the leased asset even after making the upfront payment of the lease rent.