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The Value of Cost Segregation for Hotels & Motels
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By Israel Segal, September 2008

Hotels and motels can significantly reduce their taxes through a process called cost segregation. In fact, cost segregation has become one of the most vital aspects of hotel/motel financing with tax consequences that can significantly add to a facility’s bottom line. 
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For the IRS issued guide to to Cost Segregation Audit Techniques - go here
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According to federal tax laws, cost segregation consists of identifying personal property assets that are grouped with real property assets, then separating personal assets for tax reporting purposes. In order to do this, one must hire an experienced engineer who should have a well-rounded understanding of construction finance, to produce a cost segregation analysis that identifies and classifies personal property assets so that depreciation time is dramatically truncated thus reducing one’s tax obligations. 

What is personal property? It consists of a building’s non-structural elements, exterior land improvements, and indirect construction costs.

The engineer that one retains will examine all blueprints as well as architectural drawings, electrical plans, and isolate structural and mechanical components from those that are considered personal property. The cost segregation report will also identify architectural and engineering fees that can be segregated. 

The report will identify  “soft costs,” such as architectural and engineering fees, that are components of the building. In addition a well documented and thorough cost segregation analysis will do the following:

  • Maximize tax savings by adjusting the timing of deductions. 
  • Create an audit trail to help resolve IRS inquiries. 
  • Take advantage of retroactive benefits. Hotel/motel owners and operators can capture immediate retroactive savings on property added since 1987. The rules have been amended so that you can now take the full amount of an adjustment in the year the cost segregation is completed. 
  • Provide significant opportunities to reduce real estate tax liabilities. 
  • And, under certain circumstances, permit hotel/motel operators to qualify for a special 30% bonus depreciation allowed by the Job Creation and Worker Assistance Act of 2002 or a 50% bonus depreciation allowed under the Jobs and Growth Tax Relief Reconciliation Act of 2003.
The cost segregation study will identify building costs that would normally be depreciated over a 27.5 to 39-year period, then reclassify those costs, resulting in an accelerated method of depreciation. Such non-structural costs for such items as carpeting, wall coverings, some aspects of an electrical system, decorative lighting, indoor and outdoor plants, sidewalks, and landscaping, can all be depreciated  during the much shorter periods of five, seven or fifteen years.

The larger tax deductions will result in increased cash ?ow and a lower cost of capital, especially during the ?rst few years following an expansion project, renovation, or purchase. A cost segregation study can significantly help identify opportunities for such periods of accelerated depreciation. 

In order for hotels and motels to take full advantage of cost segregation opportunities, buildings must have been purchased, constructed, renovated, or expanded after 1987. While cost segregation is cost effective for such new buildings, a well done study can uncover tax deductions for buildings that pre date 1987. In addition, buildings that are best suited for cost segregation should have a cost basis that is greater than $500,000. 

In addition to providing tax relief, cost segregation can benefit the owners and operators of hotels and motels in the following ways:

  1. Maximizing tax savings by adjusting the timing of deductions. When an asset’s life is shortened, depreciation expense is accelerated and tax payments are decreased during the early stages of a property’s life. This, in turn, releases cash for investment opportunities or current operating needs. 
  2. Creating an audit trail. Improper documentation of cost and asset classifications can lead to an unfavorable audit adjustment. A properly documented cost segregation helps resolve IRS inquiries at the earliest stages. 
  3. Playing Catch-Up: Since 1996, taxpayers can capture immediate retroactive savings on property added since 1987. Previous rules, which provided a four-year catch-up period for retroactive savings, have been amended to allow taxpayers to take the entire amount of the adjustment in the year the cost segregation is completed. This opportunity to recapture unrecognized depreciation in one year presents an opportunity to perform retroactive cost segregation analyses on older properties to increase cash flow in the current year. 
  4. Additional tax benefits. Cost segregation can also reveal opportunities to reduce real estate tax liabilities and identify certain sales and use tax savings opportunities. 
Under certain circumstances, segregated assets may qualify for a special 30% bonus depreciation allowed by the Job Creation and Worker Assistance Act of 2002 or a 50% bonus depreciation allowed under the Jobs and Growth Tax Relief Reconciliation Act of 2003.

An example of Cost Segregation: Suppose an individual purchases a hotel/motel for $10,000,000 while the land is owned by another entity. If the purchaser does not use cost segregation, then straight-line depreciation over 39 years must be used.

If, however, an engineer is retained and produces a report that shows that of the total purchase price, $9,000,000 should be for the building and $800,000 for a parking lot, and $50,000 for landscaping and shrubbery, the hotel owner could save more than $100,000 assuming a tax rate of 35% and 5% discount rate. 

There is an another example of the tax savings that can result from cost segregation. Suppose a cost segregation analysis shows that a buildings siding had an initial value of $200,000. Five years later, it has a value of $150,000 and must be replaced. The hotel/motel owner could deduct $150,000 as a loss. Without a cost segregation study, the owner would be not able to take the deduction because the siding’s tax basis and the cost basis of the building would not have been itemized as separate  entities.

Altogether, a  cost segregation study is an essential fiduciary component when one does any of the following:

  • Building a new hotel/motel, 
  • Acquiring an existing building,
  • Renovating an existing hotel/motel, or
  • Expanding an hotel/motel. 
Owners and operators of hotels and motels who do not hire the appropriate experts to conduct a cost segregation analysis will fail to take advantage of  significant tax benefits.

Israel Segal is president of VFR Finance, which specializes in all aspects of hotel/motel financing. The firm’s website is www.vfrcs.com. For further information, please write info@vfrfinancial.com
 

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Contact:

Jeffrey Sussman
212-421-4475
marketingpro@aol.com
 

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Also See: Depreciating Assets: What Hotel Owners Should Be Considering / Kevin F. Reilly / July 2004
Winds Blow in Washington DC; Tax Code Changes Affecting The Lodging Industry / May 2006
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