A bargain purchase option in a lease agreement allows the lessee to purchase the asset at the end of the lease at a significantly lower price than its fair market value, making it a capital lease and obligating the lessee to include the asset on its balance sheet. The lessee is responsible for taxes, insurance, and maintenance, and can only claim the interest portion of the lease payment as an expense for tax purposes.
A bargain purchase option is a stipulation included in a lease agreement that gives the party leasing an asset the first option to purchase the asset at the end of the lease. The price that the leasing party, or lessee, must pay for the asset at this point is significantly less than the fair or market value of the asset. It is for this reason that a purchase option on a lease automatically qualifies it as a capital lease. If this is the case, the leasing party must include the asset on its balance sheet as part of its financial reporting obligations.
When a party enters into a lease, they are essentially paying for the right to use an asset without gaining ownership of it. The property remains in the hands of the party known as the lessor. However, in some cases, the lessee actually has an opportunity to obtain ownership of the asset in question after the lease has been completed. If the offered price is well below the asset’s fair market value, it is known as a low-price call option.
Any time a lessee is involved in a lease that has a low-price purchase option, there is a general assumption that the option will be exercised and ownership will transfer from the lessor to the lessee. After all, the lessee is obtaining possession of the asset at a better price than others not involved in the lease could pay. There are financial realities to this type of arrangement that must be considered.
If a lease has a purchase option at a good price, it meets one of four criteria that automatically make it a capital lease even before the option is exercised. Once a lease has been deemed a capital lease, the lessee must include the asset as part of its balance sheet. In essence, the lessee becomes the owner of the lease along with all the financial benefits and inconveniences associated with it, with only title actually remaining with the landlord.
What this means for the lessee involved with a purchase option is that they must pay all taxes and insurance associated with the asset and take responsibility for maintaining it. In addition, only the interest portion of the lease payment can be claimed as an expense for tax purposes, although the lessee does get the benefit of the asset’s depreciation on their taxes. These rules are in place to prevent a lessee from obtaining financing that does not appear on the lessee’s financial statements.
Smart Assets.
Protect your devices with Threat Protection by NordVPN
