Hotel and Motel Owners Exchanging Out: Franchise, PIP and the Whole-Transaction Sale

A hotel sells as a business, so the allocation schedule is the first document to negotiate, not the last

A buyer of a hotel acquires land, a building, the furniture in every room, the franchise, the liquor and operating licences, inventory and the goodwill of a running operation. Section 1060 applies to any transfer of "assets which constitute a trade or business" and makes a written allocation "binding on both the transferee and transferor unless the Secretary determines that such allocation (or fair market value) is not appropriate." The hotel property page walks through the residual method class by class; here the question is the owner's: how to sequence the sale so the exchange, the franchise and the furniture each land where they should.

Only one line of the schedule can be deferred. Reg. section 1.1031(a)-3(a)(2)(ii)(B) names hotels and motels among buildings, and paragraph (a)(5)(ii) says a licence or permit "to engage in or operate a business on real property is not real property." The franchise, the brand and the goodwill are therefore taxed in the year of sale whatever happens to the building.

The advantage of a whole-transaction sale is that the going concern's value, the thing a buyer pays most for, is priced into one contract. The cost is that the buyer's incentive runs toward the furniture and the intangibles it can depreciate and amortize quickly, and every dollar moved there is a dollar out of the exchange.

The franchise agreement decides whether the buyer keeps the flag and who pays for the property improvement plan

A filed relicensing franchise agreement for a branded select-service hotel, attached as an exhibit to a lodging REIT's Form 10-K, shows the mechanics. A transfer is "prohibited without the prior written consent of Franchisor." The buyer must "complete and submit to Franchisor a new franchise application" and pay the then-current application fee as a transfer fee, of which $10,000 is retained if the application is denied. The new agreement must "provide for the upgrade of the Hotel to address any needed renovations and to bring the Hotel into compliance with Franchisor's then-current Standards" under a property improvement plan, with a non-refundable PIP fee, currently $10,000 in that agreement.

That PIP is the number buyers negotiate against. A hotel whose soft goods are due, under the same agreement's five-to-six-year cycle for soft goods and ten-to-twelve-year cycle for case goods, carries a renovation the buyer will price into its offer. Commission the PIP estimate before you list so you negotiate from the franchisor's figure rather than the buyer's.

Selling unflagged is the alternative, and it has a price too. The agreement's liquidated damages on termination equal the average monthly franchise and marketing fees over the prior two years multiplied by the lesser of 36 or half the months remaining in the term, with a 150% multiplier if the hotel goes to a competitor brand, and the franchisor holds a right of first refusal on a sale to a competitor at the same price. Franchisees who sell the real estate and keep the franchise covers the opposite structure.

The furniture is ordinary income on a mature hotel, and the section 1245 rule says so notwithstanding anything else

Section 1245(a)(1) treats gain on section 1245 property, up to the depreciation previously taken, as ordinary income that "shall be recognized notwithstanding any other provision of this subtitle." Furniture, fixtures and equipment are personal property under section 1245(a)(3)(A), and on a hotel that has been through a replacement cycle most of it is fully depreciated, so the whole FF&E price is recapture.

The furniture cannot be put into the exchange. The incidental property rule in Reg. section 1.1031(k)-1(c)(5) lets personal property worth no more than 15% of a larger item of property be ignored for identification, but it does not make the furniture like-kind; the gain on it is recognized either way.

The franchise and the goodwill are taxed too, but differently. Section 197(d)(1)(F) lists "any franchise, trademark, or trade name" as an amortizable intangible for the buyer; for you, the goodwill of a long-held hotel is generally capital gain, and that gain, unlike the furniture recapture, is eligible for deferral in an opportunity zone fund within 180 days under Reg. section 1.1400Z2(a)-1(b)(11), which requires gain "treated as a capital gain for Federal income tax purposes or is a qualified 1231 gain."

Worked model: a $12,000,000 branded hotel with a $5,000,000 loan

These figures are hypothetical and rounded. An owner sells a 120-room branded hotel for $12,000,000 with a $5,000,000 loan. The written allocation puts $9,500,000 on the real estate against a $4,000,000 basis, $1,200,000 on fully depreciated FF&E, $300,000 on the franchise and licences, and $1,000,000 on goodwill. The buyer takes the flag and a $1,500,000 PIP.

• Real estate: $5,500,000 of gain, including the straight-line depreciation that would be unrecaptured section 1250 gain at up to 25% under Topic 409 on a cash sale, deferred in full if $9,500,000 is reinvested and $5,000,000 of debt is replaced within 180 days.
• FF&E: $1,200,000 of ordinary income in the year of sale. No exchange, no opportunity zone deferral.
• Goodwill and franchise: $1,300,000 taxed in the year of sale; the capital-gain portion can go to an opportunity zone fund within 180 days of the sale.
• PIP: carried by the buyer under its new franchise agreement, which is why it shows up as a lower price rather than a line on your return.
• Re-run the allocation with your CPA before the purchase agreement is signed; once it is written it binds both sides.

Sequence the contract so the intermediary receives the real-property price and nothing else

A single purchase agreement can carry the whole hotel if it states the allocation and directs the real-property price to the qualified intermediary at closing while the FF&E, franchise and goodwill prices are paid to you or your operating company. Reg. section 1.1031(k)-1(b)(2) starts the 45-day and 180-day periods on "the date the taxpayer transfers the relinquished property," so a delayed franchisor consent that pushes the closing moves the whole calendar with it.

If the real estate and the operation sit in one S corporation, the corporation is the exchanging taxpayer and must take title to the replacement; the owner-occupied building guide covers the entity questions, and the hotel property page covers selling the operation to one buyer and the real estate to another.

Replacement: a financed DST in net-lease or multifamily property, because hotel DSTs barely exist

Rev. Rul. 2004-86 treats a DST beneficial interest as an interest in real property, but it also bars the trustee from renegotiating leases or making more than minor non-structural changes, which is why trusts holding operating hotels are rare; hotel and hospitality DSTs explains the master-lease structure the few that exist use. Most hotel sellers move the real estate proceeds into traditional DSTs holding net-leased or multifamily property: a financed trust supplies the non-recourse debt that replaces the hotel loan, an all-cash trust fits an unencumbered sale, and net lease DSTs trade nightly room revenue for a fixed rent. The interests cannot be sold on demand, the sponsor controls the sale date, and the property can lose value, so the principal is at risk.

An operator who wants to keep deciding when to sell can hold title through a direct title security with management in place, and the goodwill gain that cannot be exchanged has its own route through an opportunity zone fund.