Prepaid LeaseDefinition and Benefits of Prepaying your Lease

Owning or renting – which one is better?

When it comes to the properties that will be used for your business, it can go two ways.

One is to own the property which will then be recorded in the business’s books as an asset.

The other is to rent the property.

You won’t be recording the property as an asset.

However, renting is usually cheaper than purchasing, so that could be why businesses opt to rent than to own.

Another benefit of renting is that you don’t have to commit to the full useful life of the property.

I mean, you can still do that if you own the property, but you’d have to deal with its disposal.

Renting a property goes away with that.

Once the contract is done, you can just stop renting .

No need to deal with the pains of asset disposal.

Lastly, by not recording an asset (by opting to rent rather than own), certain financial ratios of the business won’t be distorted.

Particularly, ratios that involve assets in their computation (e.g. Return on Assets, Asset Turnover, Solvency Ratio).

Since you won’t be accumulating assets, your total asset figure will not be changed.

But I’m not saying that renting is always better than owning a property.

It will still depend on the type of property and business.

But that’s a topic for another day.

We won’t be expounding that in this article.

Rather, we’ll be focusing more on renting.

More particularly, prepaid lease.

In this article, we will discuss what a prepaid lease is and its core requirement.

We will also be discussing how it benefits both the lessor and lessee.

Finally, we will be discussing the things that you should be aware of when entering into a prepaid lease contract, especially if you’re the lessee.

What is a Prepaid Lease?

A prepaid lease is a lease contract that grants one party the right to use a tangible asset.

The other party provides the tangible asset itself but does not give up ownership over it.

A tangible asset is any asset that has a physical form such as land, building, machinery, and equipment.

A typical prepaid lease will involve the leasing of an asset for several periods.

What makes it different from a usual lease is that there is usually a prepayment.

The amount will depend on what’s stated in the lease contract.

There are two parties in a prepaid lease contract: the lessor and the lessee.

The lessor is the one responsible for providing the property to be leased.

In exchange, the lessor receives a certain amount of compensation, more commonly known as rent.

The lessee is the one that is granted the right to use the leased property.

By paying the lessor as per the contract, the lessee is allowed to use the leased property.

What makes a prepaid lease contract different from a sales contract is that the ownership of the property is not transferred to the lessor.

This makes it beneficial for the lessor as aside from receiving lease income, s/he can claim depreciation expenses.

This is not possible when the property is sold instead of leased.

On the lessee’s part, since s/he won’t be owning the property, s/he won’t have to worry about property taxes.

The lessee can also treat the prepaid lease just like a regular lease contract, except that prepayment has been made.

So instead of making monthly payments, the prepaid amount is amortized over the term of the lease.

Plus, a prepaid lease usually comes with reduced rates, so it could save the lessee money as compared to making regular lease payments.

Core requirements of a Prepaid Lease

Aside from the prepayment, there are other things to consider before a lease contract can be treated as a prepaid lease.

These are the following:

The lease term must not exceed 80% of the leased property’s remaining useful life.

Every tangible property (except for land) has a set useful life.

By the way, useful life refers to the estimated length of time the property will remain in service.

For example, you can usually use a laptop for three to four years before it declines in performance.

That means that a laptop has a useful life of three to four years.

While some properties can still be operated beyond their assigned useful life, their operational efficiency tends to decrease.

As such, properties that are beyond their useful life are rarely kept by businesses.

That said, take note that the lease term of a prepaid lease must not exceed 80% of a leased property’s remaining useful life.

Emphasis on “remaining” as it might be mistaken for the leased property’s full useful life.

For example, a piece of equipment was estimated to have a useful life of 5 years.

It was already used for 3 years by the time you were able to lease it. As such, it only has 2 years of remaining useful life.

The 80% threshold for the lease term will then be based on the 2 years remaining useful life.

Meaning that the least term must not exceed 1.6 years or 1 year and 7.2 months.

The residual value of the leased property must at least be 20% of its original cost

Residual value refers to the estimated value of the leased property when the lease term ends.

It’s the amount that the least property can be reasonably be sold for at the end of the lease term.

For a lease contract to be considered a prepaid lease, the residual value of the leased property must at least be 20% of its original cost.

As an example, you enter into a lease contract where you lease a service vehicle that originally cost the lessor $50,000.

For it to qualify as a prepaid lease, the residual value of the service vehicle must at least be $10,000.

The lessee is granted a purchase option, however the purchase price must be for a reasonable amount.

Meaning that it cannot be a bargain purchase option.

For example, if the leased property has a residual value of $5,000, then the purchase option must be valued at an amount close to the residual value.

If it is a nominal amount, it will be considered a bargain purchase option.

The lease will not be considered a prepaid lease then.

Purchase option refers to the ability of the lessee the purchase the leased asset at the end of the lease term.

It is usually granted for long-term lease contracts.

If the lessee exercises the purchase option, the ownership of the leased property will be transferred to him/her.

All of these requirements must be met.

If any of the three core requirements aren’t met, then the lease contract won’t be considered a prepaid lease.

Benefits of entering into a prepaid lease contract

While it may look like a prepaid lease contract is only beneficial to the lessor, it actually benefits both parties.

Here are some of the benefits of a prepaid lease:

For the lessor

• The lessor can amortize the prepayment over the lease term. This way, the income is evenly distributed as well as the tax burden. Furthermore, doing it this way may reduce the lessor’s annual income enough to put it into a lower tax bracket resulting in more money saved
• Since the lessor still owns the leased property, s/he can claim depreciation expense. This further reduces the taxable income of the lessor, which also means lower tax liability
• From the lease alone, the lessor can gain back about 80% to 90% of the leased property’s fair value. Should the lessee avail of the purchase option, the money received is an additional gain
• By amortizing the prepayment over the lease term, the lessor can have a consistent inflow of income instead of sporadic sales

For the lessee

• A prepaid lease is usually cheaper than a lease with regular payments. This alone saves the lessee money
• Since the ownership of the leased property isn’t transferred to the lessee, s/he won’t have to worry about property taxes
• Also related to the previous point, the lessee won’t have to recognize depreciation expense
• A prepaid lease provides the lessee a purchase option; if the lessee wants to acquire ownership of the leased property when the lease terms end, s/he can avail of the lease option

What to be aware of when entering into a prepaid lease contract

While a prepaid lease has its benefits, there are things that you need to consider when entering into one.

Especially if you’re the lessee.

For example, while it could be considered that not owning the leased property is beneficial, you must also put into mind that you already paid a considerable amount just to use it.

So essentially, you’re paying for its value without legally owning it.

Other things to consider are:

• Since ownership is not transferred to the lessee until s/he avails of the purchase option, s/he cannot include the leased property in the balance sheet; this may be important if the lessee is looking to build up his/her balance sheet by accumulating assets
• Not recognizing depreciation expense also has its downside. Since depreciation expense reduces the taxable income, it also reduces the tax liability; the lessee cannot avail of this tax benefit
• Lastly, the lessee carries of the lessor going bankrupt. Should the lessor become bankrupt, his/her lenders will then have the right to seize his properties, including the leased property that the lessee already made an upfront payment for; if the leased property is seized before the lease term ends, then the lessee essentially partially paid for nothing