Tax benefits of intangibles are often lost
28 SEPTEMBER 2015 7:42 AM
Recognizing intangibles that are acquired when buying an operating hotel can provide income tax benefits. Here’s what you need to know.
Recognizing the contributory value of the basket of intangibles acquired when buying an operating hotel provides significant income tax benefits inasmuch as the Internal Revenue Code, under Section 197, allows 15-year amortization for qualifying assets. If these are not separated from the real estate, this value simply becomes part of the 39-year depreciation.
Many tax-paying owners take advantage of the IRC’s depreciation rules that allow certain items of the real estate, sticks and bricks, to be segregated and reclassified as shorter lived assets. This entails a cost segregation analysis, which typically requires a trained tax professional to identify the building components that qualify under the rules. However, most cost segregation preparers do not have the ability to either identify or quantify intangible assets so this additional allowable benefit is lost.
In Scenario I above, the cost segregation preparers would start with the building component of $7,600,000 to identify components that are allowed under the IRC to be reclassified for quicker depreciation. Typically for an operating hotel about 15% of the total building value qualifies to be re-classified. Therefore, as no allocation is made to the intangibles the benefit of 15-year amortization for the qualifying intangibles versus 39 year depreciation is lost.
In Scenario II above, in addition to the benefits of cost segregation reclassifying about 15% of the building components, this owner also will receive the benefit of 15-year amortization for the $2,000,000 attributed to the intangibles which equals an annual deduction of $133,333 versus an annual deduction of $51,282, assuming straight line depreciation. Assuming a 40% tax rate, 10% reinvestment rate and lifetime hold on the asset, this additional benefit is worth approximately $200,000.
Stated alternatively, for every $1,000,000 of qualifying Section 197 assets, there is approximately $100,000 to be gained by recognizing the intangibles. Certainly the numbers are all relative but considering there are other state and local tax benefits to quantifying the intangibles if done at closing, such as reduced realty transfer tax rates and reduced exposure to prospective real estate tax increases, why throw this benefit away?
Sometimes the controversy stems simply from a lack of understanding as to exactly what the intangibles acquired are. Those trained in accounting have a mindset to think of intangibles as identifiable and able to be valued as a standalone asset. Some accountants simply have a mindset that intangibles are bad and do not want any on their balance sheets. So if the accounting treatment determines the income tax treatment, this benefit is lost.
Most income tax professionals, on the other hand, recognize that the purchase of an operating hotel has an intangible component and that this component, whether it is called goodwill or going concern, qualifies as IRC Section 197 assets and 15-year amortization.
Another issue leading to the lost intangible benefit is the tendency of real estate appraisers, when valuing an operating hotel, to opine that the operation has “no business value.” This modus operandi is the result of misguided thinking that only real estate can be pledged as collateral for lenders, thereby leading appraisers to try to put as much value in the real estate category as possible. However, as anyone that has secured a loan for an operating hotel knows, it is not just the real estate that is pledged as collateral. Everything is pledged as collateral: real estate; furniture, fixtures and equipment; and the operation. If a default occurs, the lender takes everything—not just the real estate.
So when an owner wants to quantify the value of the intangibles for income tax purposes, how does he do it?
It is difficult to find someone qualified to value the going concern, or intangible, component as most real estate appraisers do not do it and most cost segregation preparers do not do it. But there are qualified industry professionals who can do it and usually do it for buyers at the time of acquisition. Then it’s just a matter of giving the better information to the cost segregation preparers—like in Scenario II above.
Many strides have been made over the past 20-plus years in recognizing the complexity of an operating hotel asset.
In 1993, when the Internal Revenue Service developed Section 197 allowing intangibles to be amortized over 15 years, the door was opened for hotel owners to reap another benefit of their risk-taking position and quantify the increment of value attributed to the going concern that employs professional management and pays for a trade name and reservations system and a trained workforce.
And more recently many owners are taking advantage of this opportunity to reduce exposure to real estate tax increases by quantifying the value of the goodwill and not including it on a realty transfer tax return or deed recording. Just add the income tax benefit.
Bernice T. Dowell is the President of Cynsur, LLC and a former Senior Manager of Paradigm Tax Group. 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 Masters of Science in Finance program and focused her senior thesis on the topic of hotel investment analysis and the contributory value of a tradename to a going concern.
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