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November 15, 2018 Practice Point

Hotel Valuation: Deduction for the Return on FF&E

By Gauri S. Samant, Fredrikson & Byron P.A., Minneapolis, MN

An operating hotel is an amalgamation of distinct but essential components that contribute to its value: real property (land and improvements) as well as non-realty items including: (1) personal property (furniture, fixtures, and equipment or FF&E) and (2) intangible property (such as franchise brand or flag, goodwill, contracts, and reputation).  As many jurisdictions tax only real property, valuing a hotel for property tax purposes involves distinguishing the real property components from the personal property components and the intangible property components.1

There is widespread agreement that in extracting the hotel’s personal property components, a deduction is allowable under the income approach methodology for (1) a cash reserve for periodic replacement of FF&E in the future as existing FF&E is no longer serviceable (the replacement allowance), and (2) a recovery for the invested capital in FF&E (the return of FF&E).  A source of contention, however, and the impetus for conflicting state tax court decisions across the nation, is whether an additional deduction is allowable for the amount received as income for use of the investor’s investment in the FF&E until that invested capital is fully consumed and requires replacement (the return on FF&E).  Opponents to the additional deduction consider it to double-count values, asserting that the deductions for the replacement allowance and for the return of FF&E fully extract the value of the existing FF&E currently used in hotel operations.2

Supporters, however, conclude that the double-counting argument offers a myopic view that conflates the precise and distinct purpose for each deduction.  The replacement allowance does not provide a return based on the value of the existing FF&E; it is simply a reserve to replace existing items of FF&E as they wear out.  The deduction for the return on and return of FF&E is needed to provide a complete return with respect to the value of the existing FF&E under the income approach: it does not provide any return for FF&E put in use in the future after the current FF&E wears out and is replaced.

Simply put, no investor would invest capital without expecting complete recovery of the invested capital plus a payment for the use of capital.  Some courts have concurred in this holistic understanding, allowing a deduction for the return on and of existing FF&E as well as for reserves for future FF&E.3   Without quantifying and removing each one of these three items, the underlying role of FF&E in hotel operations and the investment rationale for investing in FF&E is vitiated.

1 See e.g., SHC Half Moon Bay, LLC v. Cty. of San Mateo, 226 Cal. App. 4th 471, 478 n.5 (Cal. App. Dep’t Super. Ct. May 22, 2014) (providing that the Rushmore Approach for valuing a hotel “separates the business component by deducting management and franchise fees from the hotel's stabilized net income and handles the tangible personal property component by deducting a reserve for replacement along with the actual value of the personal property in place.”) (citing Chesapeake Hotel LP v. Saddle Brook Twp., 22 N.J. Tax 525 (N.J. T.C. Oct. 26, 2005).

2 See, e.g., RRI Acquisition Co. v. Supervisor of Assessments of Howard Cty., 2006 WL 925212, at *5 (Md. T.C. Feb. 10, 2006); Chesapeake Hotel LP v. Saddle Brook Township, 22 N.J. Tax 525, 528, 531–32 (N.J. T.C. Oct. 26, 2005). 

3 See e.g., PRKM, Inc. v. Cty. of Hennepin, Nos. TC-7373 & 8564, 1991 WL 227922, at *5 (Minn. T.C. Oct. 4, 1991).