A limited partnership was recently formed to invest in a building on highway I-64 in Louisville, Ky. The purchase price was $3,050,000, and $635,000 in cash was required at the closing. To supply this cash and to refurbish the acquired property, the partnership intended to raise $945,000. The rest would be financed through a short-term note and mortgages. Initially, partnership interest was offered in units of $3,000 each, with a minimum of nine units per purchaser. When some partners invested more than the minimum, the smallest commitment was later reduced to five units. Because the offering was private, it was restricted by Securities and Exchange Commission rules to 35 participants.
So far, anyone remotely familiar with managing excess personal capital will recognize the outlines of a standard real estate tax shelter. In it, a limited partner would typically hope to realize tax-benefited returns in the vicinity of 15% per year.
But this particular investment departed markedly from the norm: The real estate involved was a 120-room hotel, instead of the usual office building or apartment complex. With such a purchase, a limited partner can look for aftertax returns around double those of conventional real estate shelters, according to Philip J. Brookes, an Irving, Tex., hotel investor and manager who has been organizing similar partnerships for several years.
One of the few organizers in the country whose shelter programs specialize in mid-sized hotel purchases, Brookes points out that a hotel is more an operating business than a rental property. This aspect, when combined with the highly leveraged, nonrecourse type of financing that the 1981 Economic Recovery Tax Act continues to allow in real estate shelters, can result in impressively higher yields than in other real estate ventures. (Though tax sheltering must be done "at risk" as stated in the Internal Revenue Code Section 465, the holding of real estate is specifically exempted; thus nonrecourse financing, for which the borrower is not liable, is permitted.)
The key to a hotel purchase vs. a commercial deal is the comparatively large percentage -- some 20% to 30% of the purchase price compared to the 5% or so of a straight office or apartment venture -- that goes toward furnishings and fixtures, which are considered personal property for tax purposes. The shorter write-offs for personal property -- explicitly given a five-year life by the Economic Recovery Tax Act of 1981 -- significantly increase the sheltering ability of hotels. Also, in certain situations, part of the expenditure for personal property will qualify for investment tax credit.
But it is to the tax treatment of the building itself that ERTA has brought what Brookes calls "dramatic changes," These include a 15-year life for purposes of depreciation (as opposed to the 20- or 30-year period assumed in the past), and the option of electing still faster depreciation through the Accelerated Cost Recovery System (ACRS). In fixing, the life of a building at 15 years and personal property at 5 years, the new laws eliminate the constant bickering between investors and the Internal Revenue Service over what constitutes a fair useful life, and make depreciation schedules nearly audit-proof. Most investors will elect the straight-line method of depreciation over the ACRS alternative, since there is no recapture; commercial real estate using ACRS is subject to full recapture, usually at ordinary-income rates rather than as capital gains. Because the depreciation is three times faster for personal property than for buildings, first-year depreciation of a hotel can run some 25% more than on other commercial property.
There are other differences as well. Although hotel investment -- depending as it does on the success of the business within -- is far riskier than ordinary commercial purchases, it is a better inflation hedge. Where commercial property is apt to be ensnared in long-term leases, hotel "rents" can be upped virtually overnight in response to inflationary needs. Nor, Brookes adds, is a hotel subject to rent control, as an apartment building might be. Also, a successful hotel produces more net rental per square foot than conventional buildings.
Another distinction of hotels is that investment interest deductions are unlimited. This tax advantage is due to the fact that the hotel is a business, rather than "property held for investment," as the Tax Code calls it. In the latter instance, interest deductions are limited to $10,000 per year plus the taxpayer's net investment income, and is zero in the case of a trust -- both significant factors in estate planning. But, Brookes warns, a potential investor should recognize that if a hotel is purchased by a limited partnership in a sale/leaseback arrangement with the seller retaining actual operation of the property, the venture would then hold investment property and the limitation would apply.
As an example of how the figures come together based on actual allocations from a recent partnership, take a property purchased for $5 million. The land (which isn't depreciable) cost $500,000 -- or 10% of the total; the building cost $3,400,000, is depreciated over 15 years, and comprises 68%; the fixtures -- the personal property -- make up 22% or $1,000,000, and have a 5-year life. In the first year, depreciation of about $391,700 will be taken on the building and personal property, compared to approximately $300,000 in department that would have been taken on a conventional building in which 5% of the purchase price would have been allocated to personal property and 85% to the building.
Heightening the current attraction of such sheltering ability is the availability of favorable financing. Largely as the result of a spate of hotel bankruptcies in the mid-1970's, traditional lending institutions are either steering clear of moderate-sized hotels altogether, or are exacting stiff equity and revenue-sharing kickers from the borrowers, thus discouraging potential buyers. Consequently, sellers are willing to finance sales at terms and rates that are often considerably more favorable than those prevailing at the time. The lower down payment and enhanced leverage opportunities that thus might be available through concessions made to the buyer result in better cash flow than conventional deals.
And none of these investor benefits, Brookes adds, take into account the potential appreciation of the property that a partnership would hope for. A well-located, efficiently run mid-sized hotel can add 20% to 60% pretax return per annum upon selling, he says.
But any investor should understand that no deal with yields that can net 50% after taxes comes without risk. Hotel investment is riskier than most, and each package must be evaluated carefully for chances of success. If the investment doesn't work out as expected, there's no ready market for selling partnership units to bail out of a position. And anything as complicated as the deduction and depreciation options inherent in a sophisticated shelter demands the scrutiny of a competent tax lawyer.
Most hotel partnerships so far have been private, although there are some syndicated public pools for hotel purchases that are in the formative stage. If, after weighing the risks against the rewards, an investor wants to get in on a private placement (organizers are not allowed to advertise, except through after-the-fact tombstones), Brookes advises him or her to determine who is putting together such deals and then to contact the sponsor, who may well be thinking of another deal.Because modest-sum hotel limited partnerships are not yet widely known or understood in private-investor circles, there's still plenty of "room at the inn" for more guests.