Legal requirements of leases

In order to prevent business firms from using leasing arrangements as a disguise for what is actually an installment loan, the internal revenue service code, Section1031, "Exchange of property Held for productive Use or investment," specifies certain conditions under which lease payments are tax-deductible. If a lease arrangement does not meet these basic requirements, the lease payments are not completely tax-deductible. In order to conform to the IRS Code, a leasing arrangement must meet the following requirements:
1- The terms of a lease must be less than 30 years. A lease with life greater than 30 years is considered a sale by the IRS.
2- The premium paid to the lessor must be " reasonable"- that is- equal to the premium being paid on leases of similar assets. a premium between 10 and 15 percent would currently (November,1981) be considered reasonable.
3- The renewal option payment must also be "reasonable." If an outsider is willing to pay a higher amount to obtain the lease, the lease cannot be renewed with the original lessee at a lower rate. This is an application of the "fair market value" concept, which is also applied to purchase options.
4- No preferential purchase option is permitted. the lessee can be given an opportunity to purchase the asset only at a price equal to or above any other offers received by the lessor.