A bargain purchase option is a stipulation included in a lease agreement which gives the party leasing an asset first choice to purchase the asset at the completion of the lease. The price which 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 bargain purchase option in a lease automatically qualifies it as a capital lease. Should this be 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, it is essentially paying for the right to use an asset without actually gaining ownership of it. The ownership stays in the hands of the party known as the lessor. In some cases, however, the lessee actually has the opportunity to gain ownership of the asset in question once the lease agreement has been fulfilled. If the price offered is well below the fair market value of the asset, it is known as a bargain purchase option.
Any time a lessee is involved with a lease that has a bargain 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 getting possession of the asset at a better price than others not involved with the lease could hope to pay. There are financial realities to this type of agreement that must be considered.
If a lease has a bargain purchase option, it fulfills one of four criteria that automatically render it a capital lease even before the option is exercised. Once a lease has been deemed a capital lease, the lessee has to include the asset as part of its balance sheet. In essence, the lessee becomes the owner of the lease along with all of the financial benefits and drawbacks attached to it, with only the title actually remaining with the lessor.
What this means to the lessee involved with a bargain purchase option is that it 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 may be claimed as an expense for tax purposes, although the lessee does get the benefit of the asset's depreciation on its taxes. These rules are in place to prevent a lessee from getting financing that does not show up on its financial statements.