A lease buyout occurs when the tenant, landlord or a third party enters into an agreement to terminate the underlying lease, absolving both sides from future responsibilities under the lease. The side that wishes to terminate the lease compensates the other party for the right to end the agreement. Lease buyouts generally occur in connection with commercial leases. How this type of transaction is treated on financial statements depends on the type of lease.
Capital vs. Operating Lease
How a lease buyout is treated depends on whether it is classified as capital or operating. A capital lease is an agreement that allows individuals to rent property for a period of a time and then either transfers or allows the tenant the right to purchase the property. An operating lease is any other lease that allows the tenant to use the property, but does not permit the transfer of the property at the end of the term.
Buying Out Capital Lease -- Lessee
When a lessee enters into a capital lease, he records an asset and a liability equal to the present value of the lease payments during the term of the lease. If the value of the leased property is less than the fair value of the total of the lease’s payment, the fair value of the property is recorded for the asset and liability. The lease asset is depreciated, and the obligation is decreased by the rental payment. In the case of a buyout, the balance of the capital lease asset and liability are zeroed out, and the difference between the asset and liability is recognized as either a gain or loss. If the lessee paid to terminate the lease, the amount paid increases the loss and decreases the gain. If the lessee was paid to terminate the lease, the amount received decreases the loss and increases the gain. The gain or loss flows through to the income statement.
Buying Out Capital Lease – Lessor.
Using the total lease payments to be received during the term of the lease, a portion of that amount will be treated as gross investment in the lease and the rest as unearned income. As the lessor receives payments, the unearned income amount decreases as the income becomes earned, and the gross investment decreases as well. If the lease is terminated, the net investment and unearned income amounts are zeroed out from the books, the underlying asset of the lease is recorded on the books at the lower of its original cost, fair value or present carrying value, and the difference between those accounts will be applied to the taxable income from the year. So if the recorded value of the asset is greater than the amount of unearned income and underlying investment, that is a gain. If it's less, it's a loss. If money was paid by the lessor to terminate the lease, that will decrease net income; if money was received, that will increase net income.
Buying Out Operating Lease
When a lessee makes payments on an operating lease, he charges it to expense during the lease term when paid. The lessor keeps the underlying asset on his books and records the income from rent as it is paid. When a buyout of an operating lease is agreed to, the party paying to terminate the lease will record a liability for the costs associated with terminating the contract. This includes the payment to the agreeing party and all associated costs, such as legal fees and loss of rental income. Once the buyout is executed, the lease becomes an expense and decreases total income.
Operating Lease Bought Out.
Given that there are no balance entries that would need to be recorded for the transaction outside of increasing cash, include the money raised from the operating lease buyout in “other income.” Be sure to include a description of the source of this other income and why you received it in your financial statement’s foot notes.
Tips and Disclaimer
When either entering into a lease or negotiating a buyout consider hiring a licensed attorney. She can ensure the agreement is valid and help protect your interests. Every effort has been made to ensure this article’s accuracy, but it is not intended to be legal advice.
- USLegal: Lease Buyout Law & Legal Definition
- Financial Accounting Standards Board: Statement of Financial Accounting Standards No. 13 – Accounting for Leases.
- Financial Accounting Standards Board: Statement of Financial Accounting Standards No. 146 – Accounting for Costs Associated with Exit or Disposal Activities.
- Financial Accounting Standards Board. "Preparing for the Upcoming Leasing Standard: What a Lessee Needs to Know." Accessed Aug. 8, 2020.
- Accounting Codification Standards. "840-10-25-1." Accessed Aug. 8, 2020.
- Accounting Codification Standards. "840-10-25-43." Accessed Aug. 8, 2020.
- Internal Revenue Service. "Publication 535: Business Expenses," Page 11. Accessed Aug. 8, 2020.
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.