by Brian Hufford, CPA, CFP
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Do you own your office building or have you built out a rented space? If so, you might have overlooked some large tax deductions that can still be realized. Most dentists are savvy about the tax advantages of purchasing equipment and expensing up to $250,000 in 2008. But many are uninformed about the highly tax-advantageous treatment of dental office buildings. These overlooked tax deductions could make the difference in the ability to own the office space of your dreams.
For many years, office real estate was of no help in the tax-savings department. Two tax-related issues prevented dentists from realizing large deductions from office buildings that could be used to offset earned income from a dental practice.
The first of these issues was the unfavorable depreciation rules for office real estate. Under the Modified Accelerated Cost Recovery System, dental office buildings were assigned a 39-year life with straight-line depreciation. Unlike the expensing and rapid depreciation used for equipment, dental office buildings provided little in terms of depreciation deductions.
The second issue dealing with taking large deductions on dental office buildings is passive activity treatment under Section 469 of the Tax Code. Most dentists own their office buildings in a separate entity from the dental practice for asset protection reasons. Typically, the dental office building is owned in a separate limited liability corporation (LLC) and is leased to the dental practice. Under the passive activity rules, even if the depreciation deductions are large, the deductions in most cases are limited to the amount of rental income and cannot be used to offset earned income from the dental practice — unless special actions are taken.
If you own a dental office building or are contemplating acquiring new space, you may have the potential to realize a large tax refund or significant future tax deductions with some enlightened tax planning.
The first step in this process is to overcome the slow 39-year depreciation under MACRS. The Hospital Corporation of America tax case was successful in establishing a tax precedent for classifying between 25% to 40% of the cost of a dental office space as necessary for the treatment of patients and making it subject to more rapid five-, seven-, or 15-year life property subject to rapid depreciation rules. This means that a $1 million building could possibly have depreciation deductions of nearly $100,000 more in the first year than under the 39-year life rules.
How does a dentist achieve these faster depreciation benefits?
To establish the amount of your building that is subject to faster depreciation under HCA, you must have an engineering firm perform a "cost segregation study." There are many firms that specialize in performing these studies. The process is relatively simple and inexpensive with the right firm. Your CPA may know of a reasonably priced firm or you can contact Hufford Financial Advisors for a recommendation.
Performing a cost segregation study is a specialized activity, and not just a matter of looking up plumbing, electrical, and component costs. We believe an engineering firm should perform the study to support the allocations before the IRS. The right firm will document cost allocations, which should withstand a tax audit.
If you built a building some years ago, you can still perform a cost segregation study and recoup the deduction if you did not take one at the time. You do not even need to amend tax returns to do this. The change in depreciation deductions is called a "change in accounting" method. This can be done prospectively, which means you do not need to amend prior returns.
Finally, welcome to tax planning in the 21st century. The real issue under the current tax code is not simply knowing about great tax planning opportunities, it is obtaining the deductions in spite of other complicated rules.
In this instance, suppose you perform a cost segregation study for a building that was constructed in 2004. You find that you have $300,000 of new depreciation deductions for 2008! This is great. But if your building is rented in a passive activity structure, the losses could be limited to rental income for the year and be stuck within the entity. Additional tax planning with a good accountant can help discover several ways to get around this problem.
In summary, if you own dental office real estate, you may have won the "tax lottery" without having known it.
Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064, or at email@example.com.