As property operations return to pre-recession levels, it seems like a good time to improve the use the of price allocation work and maximize all tax benefits.
Most often taxes are thought of in terms of “minimizing.” Actions of buyers and sellers in the marketplace are influenced by the need to paper the deal in a manner that minimizes the tax impact. Allocating the prices among the three major asset classes involved in a deal with an independent analysis minimizes the realty transfer taxes (if applicable), exposure to increases in real estate taxes and the risk of a possible bulk sales tax audit. But there is one more benefit of allocating the price at closing that is often overlooked—accelerated tax depreciation.
Federal income depreciation is a function of the “basis” of the hard assets. In other words, how the assets are booked determines the amount of depreciation allowable. Typically, the assets are booked either as tangible personal property (for example, five, seven or 10 year lives) or as real estate, broken down between land and improvements. Land, of course, is not depreciable. Building improvements are depreciable over 39 years. However, when prices are allocated among the three major asset classes—tangible personal property, real estate and intangible personal property, additional tax depreciation benefits can be achieved.
Many owners believe that simply getting a cost-segregation study post-acquisition will take care of maximizing the depreciation benefits allowed by the Internal Revenue Service, but a cost-segregation study is designed to identify components of hard assets, namely real estate, to reclassify to shorter depreciable lives (e.g. five year or seven year versus 39 year, as allowed). Intangible assets in an operating hotel, such as contracts, licenses, franchise agreements, management agreements, etc., have value that can be separated from the real property and these assets are subject to 15-year amortization versus 39-year depreciation.
The table below demonstrates how to book the assets for tax purposes to maximize benefits:
Hypothetical fixed-asset records of a $10-million acquisition of an operating hotel:
As you can see from this example, the benefits of booking the intangibles on the tax books are two-fold:
- lower land value and
- 15-year amortization versus 39-year depreciation. Because land values are supported by a check on the land-to-building ratio, when the building value is reduced by the amount of the intangibles that can be carved out, a lower land value is supported.
While much work has been done over the past 20-plus years in educating owners about the benefits of allocating the prices among three-asset classes at closing, primarily to minimize transfer taxes and exposure to real estate tax increases prospectively, the additional benefit of maximizing depreciation expense has been left out. Some of this may be due to the fact that most companies tend to keep one set of books which are set up in accordance with Generally Accepted Accounting Principles. Under the GAAP rules, CFOs and chief accounting officers typically do not want to recognize the intangibles. However, the tax treatment is governed by the tax rules and does not necessarily have to follow GAAP. Accounting, federal tax, and state and local tax are three distinct “systems” with their own sets of rules, and the correct answer for one is not necessarily the correct answer for the others.
When the IRS changed its code in 1993 to recognize Section 197 intangibles with a definitive life and allow amortization over 15 years, owners of operating hotels had a great opportunity to maximize depreciation benefits. As the industry recovers and property operations continue to improve and return to pre-recession levels, it seems like a good time to further improve the use the of the price allocation work and maximize all tax benefits.
Bernice T. Dowell is a former Senior Manager of KPMG and President of Cynsur, LLC, she has focused her career in real estate transfer and property taxes on hospitality assets and the concept of removing the value of intangibles from a going concern. She began this endeavor as an employee in Marriott’s Tax Department in 1991. While at Marriott she was a member of the inaugural class at George Washington University for the Master’s of Science in Finance program and focused her senior thesis on the topic of hotel investment analysis and the contributory value of a trade-name to a going concern.
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