(This article first appeared in Hotel Business Review. It is reprinted here with permission from the editor.)
How is it possible to generate cash savings from assets that have disposed of previously, in many cases years ago? The answer resides in recently released Internal Revenue Service (“IRS”) regulations. If you have conducted renovations of your hotel and thus disposed of assets, yet are still depreciating the disposed assets for tax purposes, the new regulations allow for a deduction of the carrying value of the disposed assets. The effect is that by deducting the carrying value of the disposed assets immediately - rather than continuing to depreciate these assets over longer periods of time - there is a net present value savings generated by the deduction.
Without taking a deep dive into the world of tax, this opportunity for an immediate deduction for disposed of assets is set forth in the recently issued IRS “Repair Regulations” and is specifically provided for in the ability to make a “late partial disposition election.”
Who Can Benefit
The profile of a business that can typically benefit from an asset disposition deduction – and the reason hospitality companies are ideal candidates – is that of one that owns and has conducted renovations on its properties. Accordingly, hospitality companies that own and thus depreciate their hotel properties for tax purposes will at a minimum want to consider if they could generate a cash tax savings from an asset disposition deduction in accordance with these regulations. Please note that since a taxpayer must have the depreciation rights to the assets, a company who is only managing hotels and doesn’t own the properties would not be in a position to generate any benefit.
Is there a Deadline?
Yes. Taxpayers can take the asset disposition deduction on their 2014 tax returns, but the benefit of deducting past dispositions cannot be taken for subsequent tax years. Previously this deduction was allowable only for the 2012 and 2013 tax years, but the latest release from the IRS extended this benefit to the 2014 tax return as well.
How Do I Know if it is Worthwhile to Take an Asset Disposition Deduction?
In order to decide if it is worthwhile to make a late partial disposition election and take an asset disposition deduction for previously disposed assets, it must first be determined whether the benefit outweighs the cost. Such determination can be made as part of an asset disposition study. However, asset disposition studies can be both time consuming and potentially costly. Therefore, it is often more prudent to first conduct a high-level assessment (or diagnostic, if you will) to ascertain if the potential deduction is sufficient to warrant conducting a full asset disposition study.
Asset Disposition Assessment or Diagnostic
The next questions are how is a high-level assessment or diagnostic conducted and what type of information is required? The information required is relatively basic and typically readily available:
- A tax fixed-asset ledger; and
- High-level building specifications: year built, wall construction type, total square feet (by floor and in total), number of stories, and roof type (i.e. gravel, tar, pitched, etc.) Any readily available summary of past renovations/repairs is helpful as well.
From there, the first step in determining if there are assets that are no longer in use but still being depreciated for tax purposes is to conduct a "trend analysis" on the fixed asset ledger. The trend analysis estimates how much it would cost to replace the entire building today, based specifically on the cost to replace the assets that are contained on the fixed asset ledger. Since the analysis is based specifically on the fixed asset ledger, it ignores whether or not all of the assets are actually still in use. In other words it captures "ghost assets" that are no longer in use but are still on the fixed asset ledger and being depreciated for tax purposes.
The second step is to estimate how much it would cost to replace the entire building based on factors unrelated to the tax fixed asset ledger, as mentioned above (i.e., year built, number of stories, etc.). Once this information is gathered, relevant cost estimates can then be applied to estimate the cost to reconstruct the building. This approach measures the cost to rebuild the structure without any regard to the assets contained on the fixed asset ledger, thus the cost to replace the entire building excludes any assets that were previously disposed of but still remain on the fixed asset ledger (i.e., it excludes any "ghost assets").
The results of these two steps are then compared. For example, if the cost to rebuild the hotel in step one (based on the fixed asset ledger) is $15 million, while the cost to rebuild the hotel in step two is $10 million, the diagnostic indicates that there could be $5 million in replacement costs of assets that have been disposed of but are still present on the fixed asset ledger. As the deduction is based on the carrying value of the disposed assets rather than the cost to reconstruct the building, in some cases further analysis may be warranted. For example, disposed assets that have a short remaining useful life would have a much lower carrying value, thus an examination of the estimated age of the disposed assets could offer additional insight, etc.
Therefore, utilizing readily available information, the diagnostic provides a directional assessment as to the reasonableness of conducting a full disposition analysis without expending much cost or effort.
Full Asset Disposition Study
Assuming the results of the diagnostic indicate that it would be beneficial to conduct a full disposition study, the focus turns to what a full asset disposition study entails and what information is required. The key aspects of a full disposition study include:
- Analysis of past renovations and repairs, focusing on the specific costs incurred and the nature of the renovations and repairs;
- Identification of the assets that have been disposed of but are still being depreciated on the tax fixed asset ledger;
- Estimation of the carrying value of the assets that have been disposed of, and thus can be deducted for tax purposes; and
- Preparation of a narrative report and schedules that provide supporting documentation for the deduction associated with assets that are still being depreciated but have been disposed of. To ensure an efficient approach, the following steps should be implemented when conducting a disposition analysis for each hotel property:
- Conduct a site inspection;
- Review construction drawings, cost information and available blueprint sets;
- Analyze the history and nature of the various renovations and repairs at the property;
- Review and categorize contractor and supplier invoices to determine detailed cost schedules associated with renovations and repairs. This is used in preparing the appropriate documentation for identifying assets that were replaced and thus disposed of previously;
- Estimate the cost to reconstruct the building that was part of the original acquired property, as well as the cost of all replacements and renovations. This provides an estimate of the portion of the original property that was replaced and thus disposed of; and
- Estimate the carrying value of assets currently being depreciated that should instead be deducted. Example – Full Asset Disposition Study
For illustrative purposes, consider the following example of a hotel that was able to deduct the carrying value of assets that were disposed of previously. The hotel made numerous renovations over the years, including work on guestrooms, common areas, the lobby, and a restaurant. In each case while they capitalized the costs associated with the new assets, they did not remove the assets that were replaced from the tax fixed asset ledgers.
The guestrooms went through major adjustments, including the replacement of wall coverings, carpet, appliances, remodeling of the bathrooms, remodeling of kitchens, fixtures, and room furnishings. The lobby and common area renovations consisted of upgrades to the carpet, fixtures, front desk, and furnishings, while the restaurant renovation consisted of changes to the wall coverings, carpet, fixtures, furniture, and back kitchen equipment.
The assets that were disposed of as part of the renovation were identified. The cost to reconstruct the disposed assets and all assets was then estimated, with the method applied dependent on the availability and condition of the fixed asset records, documentation of renovation costs, etc. This resulted in a proportion of the cost to replace the disposed assets to total assets. As this reflects the costs to reconstruct the hotel, the proportion was then applied to the carrying value of the total assets, to determine the amount that should be deducted for tax purposes related to ghost assets, thus resulting in a reduction in the company’s current cash tax liability.
This is actually a straightforward example, and the complexity can increase significantly in circumstances where there have been multiple renovations, data regarding the original assets and / or renovation assets are unavailable, etc. It is worth noting that even under what may appear to be difficult circumstances regarding the availability of data, there typically is a reasonable approach that can be taken to ascertain a measurable and supportable asset disposition deduction.
With a short window of time that ends with filing deadlines for 2014 tax returns, hospitality companies who own properties (and thus have tax depreciation rights to the assets) and have conducted renovations in the past, could realize a significant cash savings by taking tax deductions for previously disposed assets. As detailed disposition studies can become costly (depending on the number of hotel properties, size and type of structures, condition of records, and history of repairs and renovations), conducting an initial high-level assessment or diagnostic provide a practical way to gain insight into the potential financial benefits of a full asset disposition study.