by Brian Hufford, CPA, CFP®
Recent tax law changes have created the need for thorough tax planning for dentists who own office buildings. This article will walk you through the maze of tax complexity to achieve the best tax outcomes for your valuable office real estate.
Suppose that you're about to build a new office at a cost of $500,000. Traditional planning for dentists who practice as S corporations would be to own the building in a separate LLC and lease the space to generate rental income from the dental practice. This is excellent planning to create a legal separation to protect the building asset.
But this structure can be the source of some major tax headaches, especially under recent tax provisions. For newly constructed buildings, this two-entity structure creates the potential for large lost tax deductions. This is due to the tax treatment of rental LLCs as passive activities.
Rental income is passive income. In most cases passive losses cannot be used to offset income from wages or income from the dental practice. Therefore, net rental losses may offer no tax benefit in the current year.
For new office buildings, there are two sophisticated planning steps that must be properly implemented to benefit from the large depreciation deductions available to dentists who construct new office space.
According to building depreciation rules, the great majority of building costs must be depreciated over a 39-year life. This creates little potential for tax savings from constructing a building, however, under legal precedents set by tax court cases, dentists can segregate the costs of building components that are incurred directly for patient treatment.
These costs may be depreciated much more rapidly in as few as five to seven years. By performing a cost segregation study, dentists can reallocate as much as 25% to 40% of the building costs to rapid depreciation methods. The first step toward implementation is having a sophisticated cost segregation study performed.
Unfortunately, without implementing a second step, most of the tax benefits from performing a cost segregation study are lost.
Assume that with the cost segregation study, additional depreciation deductions in our building example in the first year are $50,000. Further assume that this large extra depreciation creates a tax loss in the building LLC of the same $50,000. Since this loss is a passive loss, in most cases it cannot be used to offset dental practice income. This is an effort in futility.
The important second step to avoid this outcome is a special election called an aggregation election. If the dentist meets the requirements to aggregate, the building and practice can be viewed under tax law as a single economic unit, and the large depreciation deductions in the LLC from cost segregation can be used to offset dental practice income, with an appropriate election.
For dentists who have owned existing office buildings for some time (as opposed to constructing new buildings), a different need for tax planning exists under new tax laws. With less depreciation and interest deductions, there is the potential for rental income in the building LLC, instead of rental losses.
As rent amounts grow and deductions decrease, the possibility of significant rental net income is normal. Passive income in the past was viewed as a good thing since it was not subject to the same payroll taxes as dental practice earned income.
Under new tax laws, passive income is a bad thing, subject to the new 3.8% Medicare surtax, which is in addition to any income taxes. Without proper planning, dentists can convert earned income subject to normal income taxes to passive income in the LLC, subject to the new Medicare surtax of 3.8% for married couples with incomes of more than $250,000. Further tax planning is needed.
Under the laws that exist in 2013, the appropriate strategy to minimize taxes for dentists with existing office space is quite complex. The first step is minimizing rental income from building rents from the practice to avoid passive income. The IRS can challenge rents that are under fair market value norms, so one must be wary of making rents too low.
An alternative approach would be to implement a large deductible retirement plan arrangement to drop married income below $250,000. The retirement plan strategy can be a double win with dental office building rents.
In summary, dental office buildings present significant tax planning opportunities under the current tax environment, along with the need for sophisticated tax planning strategies.
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 [email protected].
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