Allocating the purchase price of an acquired hotel has always been an important accounting issue, but in recent years this process has taken on even more relevance. This is true regardless of whether the buyer acquires the entire economic interest of an asset or just a partial purchase in a buyout of an existing partner. For tax purposes, given the acceleration of bonus depreciation in recent years, the allocation of the total purchase price can make a difference in the timing and amount of tax deductions. As a result, getting the correct allocation is important. Depending on the structure of the purchase, there are different tax elections that may be necessary in order to optimize tax deductions.
In addition to these tax considerations, if you are required to have your GAAP financial statements audited or reviewed, the traditional methods of estimating fair market value of components such as allocation based upon property tax bills are no longer sufficient. Your auditors will require an independent third-party valuation.
The purchase price of an asset includes the cost of various parts of the physical structure, internal electrical, heating, cooling, and plumbing structures. It will include the furniture and fixtures, including lobby, room furniture, and kitchen equipment. Other parts of an allocation might include inventory, goodwill, various receivables and liabilities, and land.
Allocation of the physical structure amongst the various components mentioned above can be critical for maximizing the timing and value of tax depreciation. A cost segregation study, performed by analysts who generally employ engineers on staff, identifies various classes of assets, separating personal property and land improvements from the cost of the building. The tax benefit created is that certain parts of the building such as decorative lighting or specialty plumbing are depreciated over a much shorter life than the building itself. With these accelerated deductions, taxable income can be significantly sheltered, particularly in the early years of the ownership of the property.
Some or all of the purchase price allocation may need to be agreed upon between the buyer and seller depending on the form of the transaction and the amounts allocated to the different assets. This issue should always be reviewed at the time of signing a contract. If this is necessary, the allocation needs to be determined thoughtfully if a subsequent GAAP audit (and therefore a third-party valuation) is necessary as mentioned above.
The following are some nuances on each class and the potential effects:
Intangible Assets and Liabilities and Inventory:
While these items quite often are specifically adjustments of the agreed-upon purchase price (pro-rations), it is important to identify them accurately. For instance, having an understated liability for sales tax payable could become an immediate outlay of cash, regardless of warranties in a contract. Generally, these adjustments turn around in the short-term, meaning there is an immediate impact on tax deductions.
Goodwill consists of the name, franchise, reputation, or the workforce in place. The sale of goodwill is favorable for the seller, but a not so favorable 15-year life for the buyer.
As mentioned above, a cost segregation study will determine what parts of a building fall into different class lives. There are four main lives: equipment which are 5-year lives, furniture and fixtures which are 7-year lives, land improvements which are 15-year lives, and the remaining costs are building costs, which are 39.5-year lives. In addition, all the assets, except the building, are eligible for Federal bonus depreciation, which in 2022 is a 100% deduction in the first year. However, unless extended, in 2023 the bonus depreciation gets reduced to 80% and phases out by 2026. As exemplified by this breakdown, there is usually a very good reason to perform a cost segregation study.
There are a few other issues to consider when allocating purchase price. In certain states, the purchase of personal property is subject to sales taxes or personal property taxes, which should be considered before an allocation of purchase price is done. In addition, the actual sales tax liability of the entire currently existing business can be transferred to the buyer in the process of completing the transfer.
In summary, negotiating the best price and terms for the purchase of a hotel is obviously the most important part of an acquisition. However, don’t overlook the nuances related to the allocation of purchase price as you may very well be leaving many after-tax dollars on the table!
For additional advice on potential tax savings, please reach out to Matthew Bonney at firstname.lastname@example.org or Lawrence Cohen at email@example.com for more information.
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