Numerous Tax Incentives Available to Hotel Owners

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With a recovering economy and expanding urban growth, demand for hotels is soaring. Increases in both business and leisure travel are creating a demand for new hotel construction and renovations to keep up with occupancy rates. The new regulations available for building owners allow great opportunities for reducing the costs of new hotel construction and renovations due to cost segregation and incentives for energy efficient equipment. By combining a cost segregation study at the time of purchase or new construction with a plan for taking advantage of future repairs, hotel owners can significantly reduce the costs of their initial purchase as well as any repairs that need to be addressed during the building's lifetime.

Hotel Demand Higher Than Ever

Hotel occupancy and overall revenues are now just over their 2007 pre-recession peaks, and look to be on the rise. The demand for hotel rooms increased by 2.2% in 2013, but the supply of rooms only grew by 0.08%. Forecasts estimate a further 2% per year in hotel growth through 2017. This growth is significantly increasing profits. In 2013, the revenue per hotel room increased by 5.9%, and estimates show that it will increase another 6.2% in 2014. With increasing demand, more and more hotels will need to be built to accommodate the growth.

The rising travel sector is creating a huge boon for new hotel construction, and it is expected that hotels in urban areas will have the biggest increase in demand. As seen below in Table 1, there are currently 521 hotels in construction or planning phases in the major US cities. In New York City alone, there are about 180 hotels currently in the construction or planning phase. All of this new construction means building owners are making large investments in new properties. Cost segregation and other incentives for energy efficiency can significantly help alleviate these building costs.

Table 1: Hotel Construction in Major Cities

City

Under Construction

Starting Within Next Year

Early Planning

Total

New York

91

47

42

180

Washington

17

29

39

85

Houston

23

51

26

100

Los Angeles

15

17

28

60

Chicago

10

20

12

42

Miami

22

15

17

54

Totals

178

179

164

521


Cost Segregation

Cost segregation (CS) is a method of allocating a building's assets to take advantage of the time-value of money. Established in 1997, CS leverages years of case law and the Modified Accelerated Cost Recovery System (MACRS), issued by the IRS in 1993. As opposed to normally depreciating all of a hotel's assets over 39 years, these assets are able to be broken up into different “buckets” and depreciated over quicker schedules depending on their function. In most cases, for a building, the ability to depreciate some assets over a quicker schedule can return an average of 5-10% of the project cost based on the added Net Present Value (NPV) generated. In other words, it is like a 5-10% coupon on the project.

The buckets and depreciation schedules that categorize cost segregation are illustrated below:

Table 1: Cost Segregation and Energy Efficiency Incentive Categories' Depreciation Methods

Category

Depreciation Method

Items Included

Building

39 Year

Walls, roof, foundation, building lighting, doors, beams, windows, fire protection, etc.

Land Improvements

15 Year

Parking lot, site sewer, paving, curbing, fences, landscaping, non-building related excavation, dumpster pad, exterior light posts, parks, tennis and basketball courts, dog parks, gardens, outdoor pools, etc.

Personal Property

5 or 7 year

Carpet, blinds, shelving, décor, appliances, washer/dryers, wiring and plumbing connected to appliances and machinery, mirrors, furniture, etc.

Soft Costs

Distributed across all categories

Testing, insurance, permits, blueprints, fees, architectural/engineering, construction labor, general conditions, job site security, etc.

Alternative Energy Projects

Typically 5 year

Geothermal, combined heat and power (CHP), wind, solar P.V., etc.

EPAct/Section 179D

Up to $1.80/sq.ft. first year accelerated depreciation

Interior lighting, HVAC, building envelope (walls, windows, roof, doors)


1. Building

In a hotel, the components that make up the physical building are treated as 39-year property. This includes the walls, roof, foundations, building lighting, doors, beams, windows, fire protection, etc.

2. Land Improvements

Any item or improvement defined as Land Improvements is categorized as 15 year depreciable equipment. These include the excavation of the site, paving, curbing, fencing, exterior light posts, but can also include outdoor entertainment areas such as parks or tennis courts. Most hotels, especially outside of urban areas, focus on developing their exterior areas to attract guests. Many common outdoor amenities are classified as 15-year property, including outdoor swimming pools, basketball courts and hoops, soccer fields and nets, and dog walks. In addition, many hotels are installing car charging stations; Marriot recently installed these stations in over 60 hotels. All of these outdoor improvements would be considered 15-year property, and a cost segregation study can assist in reducing the overall costs of these installations.

3. Personal Property

Items that are permanent but not integral to the building's operation are categorized as 5 or 7-year property. In a hotel, this would include items such as carpeting, tile, shelving, furniture, décor, permanent appliances, such as refrigerators, washers and dryers, as well as all electricity and piping connected to the equipment.
Hotels are one of the building types that can most benefit from a cost segregation study due to the large amount of personal property inherent in the building type. In hotels, personal property makes up a large portion of initial costs, since every guest room needs to be decorated and fitted with beds, furniture, refrigerators, coffee makers, safes, and other furnishings defined as personal property. In addition to guest room furnishings, hotels have a lot of personal property associated with the amenities and upkeep of the building. Most hotels contain a large laundry room containing washer and dryers for room linens. Most hotels additionally contain bars or restaurants, which are also full of equipment classified as personal property. Barstools, tables, chairs, stoves, grills, walk-in refrigerators and freezers, and other kitchen appliances, along with the electrical and plumbing connected to each, would all be classified as personal property and eligible for faster depreciation.

Furthermore, in an increasingly competitive hotel market, many owners are beginning to furnish the rooms with more high-end appliances and décor to gain an edge. Even properties with a non-luxury focus are including features traditionally found only in higher-end properties, such as stainless steel appliances and upgraded floor materials. With more and more hotels placing a greater focus on more expensive furnishings and appliances, performing a cost segregation study to categorize these items as 5 or 7-year property can recover much of the costs.

4. Soft Costs

Costs associated with the construction and planning of the building are distributed proportionally across all class life categories. This includes the construction labor, architectural and engineering costs, blueprints, testing, job site security, insurance, permits and other fees. When planning whether to perform a cost segregation study, the impact of depreciating soft costs must not be overlooked. With increasing urbanization, costs for permits and associated fees are rising. A cost segregation study can help reduce the strain of these increasing construction related fees.

New Repair Regulations

In October 2013, the IRS issued new permanent regulations(TD 9636) for the treatment of Capital and Repair related purchases. When performing a cost segregation study, the properties allocated into depreciation buckets can be further segregated into Building Systems, describing the role they serve in the building. These categories are as follows:
  • HVAC
  • Plumbing
  • Electrical
  • Escalators
  • Elevators
  • Fire Protection & Alarms
  • Security Systems
  • Gas Distribution
  • All Other
When faced with a future one-for-one replacement of Building System equipment, buildings that have conducted a Cost Segregation down to the Building System level may be able to expense the basis of the new equipment. The replacement must not be a betterment and must change less than 50% of that type of similar functioning Building System equipment. For example, a facility conditioned with 100 PTAC (Packaged Terminal Air Conditioners) units can replace up to 49 with similar equipment and expense the cost of the replacement, thereby reducing the after tax cost of the replacement. In the scenario where the new equipment must be capitalized, the taxpayer may be able to write off the remaining cost basis of the old assets, so long as they have identified the single cost of these assets.

Alternative Energy Credits

Alternative energy installations are being embraced more and more by the hotel sector. In addition to providing significant continual energy and monetary savings, they can also attract certain customers. Throughout the past few years, there has been a small, but growing, demand for hotels that have implemented sustainable initiatives. Many businesses and individual travelers have made a commitment to seeking out only hotels that are LEED certified or have installed energy efficient and alternative technologies. Hotels are being built to incorporate energy efficient and alternative technologies to both create continual energy and financial savings and attract this demand. In addition to LEED certification, a number of independent certification boards, many organized by state boards, have created independent certifications and rating certifications for hotels implementing sustainable initiatives. To comply with these standards and to reduce operational energy costs, many hotels are electing to install energy efficient technologies.

Most alternative energy generating technologies are eligible for an additional credit, which, depending on the technology, is eligible for anywhere between 10-30% of the project cost returned as a tax credit. Geothermal, combined heat and power (CHP), wind, solar P.V. are common technologies that are eligible for the alternative energy credit. Between the tax credit and the large continued energy savings, alternative energy projects can have a surprisingly short payback period.

EPAct Tax Credit The Section 179 (D) Tax Provisions

Another depreciation benefit comes in the form of the EPAct Section 179D tax deduction for energy efficiency. Pursuant to Section 179D of the Energy Policy Act (EPAct) and its underlying ASHRAE (American Society of Heating Refrigeration and Air Conditioning) building energy code, commercial hotels are eligible for energy efficiency tax deductions of up to $1.80 per square foot. If a building's energy reducing investment doesn't qualify for the full $1.80 per square foot deduction, deductions are available for any of the three major sub-systems, including:
  • Lighting
  • HVAC (Heating, Ventilation and Air Conditioning)
  • The building envelope
Each component can qualify for up to $0.60 per square foot EPAct tax deductions. The building envelope is anything on the perimeter of the building that touches the outside world including roof, walls, windows, doors the foundation and related insulation layers.

Energy Efficient Equipment to Trigger the EPAct Benefit

There are many different ways to trigger an EPAct benefit in hotels. Unlike utility rebates and other financial incentives for energy efficiency, EPAct is not technology-specific. As long as a building meets the overall energy saving requirements, it will be eligible for up to the $1.80/sq.ft. tax deduction. Hotel owners have found success using the benefit to pay for high-end energy efficient technologies such as LED lighting and Variable Refrigerant Flow/ Variable Refrigerant Volume units (VRF/VRV), although centralized chillers and fluorescent lighting routinely trigger the benefit as well.Hotels are one of the most favored building categories for triggering an EPAct tax deduction. In a hotel, HVAC is the largest energy-related cost. Historically, hotels have used individual PTAC units in guest room heating and cooling. If a hotel elects to install a VRF/VRV system or a central HVAC system that services the guest rooms, such as a central chiller , it can provide large continued energy costs savings, as well as likely trigger an EPAct tax deduction of up to $1.80/sq.ft.

VRF/VRV is a highly efficient air conditioning system, ideal for commercial buildings because of the ability to individualize control for different zones/rooms. The system is very beneficial for buildings with varying cooling needs, such as hotels, since individuals want to be able to control the temperature in their area. Individual control in VRF/VRV systems creates energy efficiency and allows for flexibility in building design. On average, VRF/VRVs will annually reduce total energy costs by at least 20 percent.

In addition, many hotels are currently installing LED lighting. Over the past few years, LED lighting has dropped dramatically in price while offering immense energy savings and bulb life. As costs drop so does the payback period. Certain LED lighting projects have a payback period of only two years. The total energy cost savings from combining both LEDs and VRF/VRVs can often exceed 50 percent, and trigger a $1.80/sq.ft. EPAct tax deduction.

Many hotels also have on-site parking garages. In parking garages the largest energy user is lighting, which is normally on 24/7. By retrofitting parking garages with new LED technologies or other energy-efficient lighting, hotel building owners can reduce energy costs while capturing large EPAct tax incentives of up to $.60/sq.ft.

Additionally, one of the biggest unnecessary energy uses in hotels is lights and HVAC left on and running while unoccupied. The solution to these unnecessary energy usage is occupancy sensors for lighting and HVAC, which alert the lighting and HVAC systems to turn off after no movement has been detected for a certain period of time. These sensors are eligible costs to be applied to the EPAct lighting benefit, and all remaining control costs not depreciated through the tax deduction can then be treated as personal property and depreciated over 5-years. This is a good example of how the energy efficiency tax deduction and cost segregation can combine to create large savings. By conducting a cost segregation study and incorporating it into the design phase, the energy efficiency tax deduction and alternative energy credits can be realized. By combining all three, a significant portion of the depreciable basis can be eliminated.

Conclusion

With the recovering economy and the booming travel sector that it brings, now more than ever is the time for hotel owners to take advantage of the new cost segregation and energy efficiency opportunities. Conducting these studies with experienced professionals and integrating them into the design process is the most secure way to guarantee maximized current and long-term incentives.

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