Court Decision Promises to Reduce California Hospitality Property Taxes
A May 22, 2014, decision by the California Court of Appeal may be a game changer for hotel and hospitality property owners and operators. After many years of litigation before local boards of equalization and the courts, in SHC Half Moon Bay v. County of San Mateo, there now appears to be a definitive ruling on whether the "Rushmore approach" may be used to value hotel properties.
First championed by its creator, appraiser Stephen Rushmore, the Rushmore approach is a technique that appraisers use in valuing hotel properties that is intended to remove the value of intangible assets and rights used in hotel operations.
Intangibles, which are generally exempt from property taxation, include assets such as an assembled workforce, service contracts, and hotel management and franchise agreements. Removal of such intangibles is necessary in certain contexts, such as appraisals for property tax purposes. Intangible assets and rights used in the operation of hotels are often closely intertwined with the real property, land and buildings, which are also used in the hotel's operation.
Appraisers have used the Rushmore approach to value hospitality properties for years, and the method enjoys broad acceptance in some contexts, such as with lenders that require appraisals for financing purposes. Yet the Rushmore approach has been a constant source of controversy in the valuation of properties for ad valorem property tax purposes, primarily because the approach fails to remove the entire value (or in some cases any value) of intangibles.
Stated most simply, the Rushmore approach is supposed to remove the value of intangibles through the deduction of management and franchise fees as an expense when an appraiser or assessor values hospitality properties by capitalizing the revenues generated by such properties.
In its recent decision, the appellate court specifically held that "the deduction of the management and franchise fee from the hotel's projected revenue stream pursuant to the income approach did not—as required by California law—identify and exclude intangible assets" such as workforce and other intangibles. The court also said that the taxing authority had not explained how the deduction of the management and franchise fee captured the value of the intangible property.
Unfortunately, the court's decision upheld the use of the Rushmore approach to remove the value of goodwill for the hotel in the SHC Half Moon Bay case. The court made the decision because the local board of equalization received insufficient evidence on the issue. Because the hotel's goodwill basically represented the value of its franchise, or flag, the court's decision left in place the assessment of that nontaxable intangible.
Fortunately, the appellate court provided a road map for other taxpayers to remove the value of their hotel's franchise value in the future. To achieve that result, taxpayers will have to provide more specific evidence for the value of their hotel franchise or flag, or for other significant hotel intangibles.
Savvy hospitality property owners will find several silver linings in the SHC Half Moon Bay decision. For one, although the ruling came down from a California court, its reasoning has application nationwide.
In addition, the case supports California's general standard for addressing intangibles, which is to identify, value and deduct. For hospitality properties, this means pointing out to the taxing authorities the specific intangibles used in conjunction with the real property and then obtaining an independent appraisal of each identified intangible. The appraised values for all the identified intangibles should then be added together and deducted from the overall value for the hotel, the overall value being calculated from total hotel revenues.
Also, the taxpayer in the case sought to remove the intangible value of the hotel's franchise using an accounting analysis that was intended for use in financial reporting and which assigned all residual value to goodwill. Careful reading of the Court of Appeal's decision shows that had the hotel separately valued the franchise, as it did for the workforce and other identified intangibles, the outcome might have been very different.
The SHC Half Moon Bay decision has one other benefit in that it confirms that failure by a taxing authority to remove an identified intangible is a legal issue entitled to de novo review by the courts. De novo enables the court to review the case afresh, without reference to previous reviews or assumptions by lower courts or boards. In California, such review is rarely available in judicial appeals of decisions by local boards of equalization, which are difficult to reverse in the courts.
Hospitality property owners should show the SHC Half Moon Bay case to their local assessors and follow the decision by presenting valuations for all of the intangible assets and rights used in their property's operations. If the assessor declines to remove the intangibles in accordance with the appellate court's decision, the owner should pursue their rights before the county board of equalization and in the courts.