Over the years, I have had many leasehold tenants in my Arizona rental home. As

ID: 2449614 • Letter: O

Question

Over the years, I have had many leasehold tenants in my Arizona rental home. As you know, I am not a real estate professional, nor do I have the time to actively participate in the maintenance of this property. All of the prior tenants have rented the home for 2 years or less. I was showing the home to new potential tenants and they were very interested in the Arizona home. But they were not interested in my year-by-year lease agreement that I usually offer. Instead, they proposed a lease-to-own contractual agreement.

I have owned the Arizona home since 12/31/1994. The house is in a great neighborhood, but the house has not received any major remodeling. The home’s appliances and building structure are beginning to look dated. I do not want to spend my personal savings on remodeling this house because the home’s useful life could come to an end very soon. I hired an assessor to determine the home’s current market value, but I received some bad news…. the home’s foundation is unstable.

The potential new tenants would like to rent the home for the next three years, from 1/1/2016 to 12/31/2018. Immediately following their 3-year rental period, I'd pass the home’s ownership over to the tenants. Before I accept their proposal, could you describe how this lease-to-own agreement is different than my prior year-by-year lease agreements? How will my bookkeeping journal entries be different than before? Could you provide comparison journal entries for me? And explain why each account is being debited/credited in your comparison journal entries? Lastly, do you think this lease-to-own contractual agreement is the best decision for me? What are the pros and/or benefits? What are the cons and/or negatives? Considering all pros and cons, what would you do? And why?

Explanation / Answer

lease-to-own agreement is different than my prior year-by-year lease agreements

year-by-year lease agreements is a form of financing that transfers substantially all the risks and rewards incidental to ownership over a leased asset from the lessor to the lessee. By signing the contract and delivering the leased asset, the lessor transfers economic ownership over the leased asset, while legal ownership is transferred only upon the expiration of lease, on payment of the final instalment. In a finance lease, the lessee uses the leased asset for most of its lifecycle, as with loans.

lease-to-own agreement is a lease whereby all the risks and rewards incidental to ownership over the leased asset remain with the lessor. In this case, the lessor retains the economic and legal ownership over the leased asset, while the lessee has only right of use. Upon the expiration of contract, the leased asset is returned to the lessor. Under an operating lease, the lessee uses the leased asset for less than its useful life.

year-by-year lease journal entries

Dr. Cash

Cr. Rental Income

lease-to-own lease journal entries

(1) The lessee records an asset and a liability with the PV of the MLP

Dr. Asset xxxxxx

Cr. Lease obligation xxxxxx

(2) Each cash payment will consist of an interest portion and a principal portion (which is used to reduce the lease obligation). The lessee will use the Reducing Balance Method, otherwise called the Effective Interest Method, to allocate each cash payment between interest and principal

Dr. Interest Expense xxxxx

Dr. Lease obligation xxxxx

Cr. Cash xxxx

(3) The lessee may also have to pay other related asset expenses e.g. Insurance and/or Property Taxes.

Dr. Insurance/Property Taxes xxxxx

Cr. Cash xxxxx

(4) The lessee will depreciate the asset over

A. The Lease term (if criteria 3 or 4 were met)

Or B. The Useful life (if criteria 1 or 2 were met

Dr. Depreciation expense xxxxx

Cr. Accumulated depreciation xxxx

(5) When the Lease terminates, the balance in the lease obligation account should equal the bargain purchase option or the expected residual value. To clear the lease related accounts from the lessee’s books (when there is no BPO)

Dr. Lease obligation xxxx

Dr. Accumulated Depreciation xxxx

Cr. Leased Asset xxxx

If there were a BPO, then the entry to clear the amounts, and therefore effectively exercise the option would be:

Dr. Lease obligation xxxx

Cr. Cash xxxx

lease-to-own contractual agreement is the best decision for me

year-by-year agreement reduces adminstration for the end user and allows them to simply hand the vehicle back at the end whilst paying one simple monthly repayment. These are generally efficient for organisations that are running at least a few cars due to the administration savings. A lease-to-own on other hand will have more adminstration requirements and, depending on the type of asset and the ATO guidelines for the particular balloon, will have some additional resale risk for the lessee as you must ensure the balloon amount is reached at the end of the term.

Aspects of Difference

lease-to-own

year-by-year

Definition

In lease-to-own (Also known as capital lease), the risks and rewards related to ownership of asset leased are transferred to the lessee.

A lease in which all risks and rewards related to asset ownership remain with the lessor for the leased asset is called operating lease. In this lease, the asset is returned by the lessee after using it for lease term agreed upon.

Ownership

Ownership transfer option at the end of the lease period is there with the lessee. Title might or might not be transferred eventually.

Ownership of the asset remains with the lessor for the entire lease period.

Accounting Effect

lease-to-own is treated like loan generally. Here, the asset ownership is considered of the lessee and so asset appears on the balance sheet.

year-by-year is treated generally like renting. That means, the lease payments are treated as operating expenses and the asset does not show on the balance sheet.

Purchase Option

lease-to-own allows the lessee to have a purchase option at less than the fair market value of the asset.

In year-by-year, the lessee does not have any option to buy the asset during the lease period.

Lease Term

Lease term is generally more than or equal to estimated economic life of the asset leased.

Lease term extends to less than 75% of the projected useful life of the leased asset.

Expenses Borne

In lease-to-own, lessee bears insurance, maintenance and taxes.

Lessee pays only the monthly lease payment in year-by-year lease.

Tax Benefit

Lessee can claim interest and depreciation both as lease-to-own lease is treated like a loan.

Since year-by-year lease is as good as renting, lease payment is considered as expense. No depreciation can be claimed.