Tax Planning for Office Building Groups
Dental office buildings present important opportunities for significant tax savings, yet dentists rarely realize the large potential deductions.
by Brian Hufford, CPA, CFP®
Dental office buildings present important opportunities for significant tax savings, yet dentists rarely realize the large potential deductions. The reason for lost deductions is the lack of sophisticated planning related to the complex issues of building ownership. In this column, I want to examine some of these issues for dental groups that construct and build larger buildings that are home to several dental practice units.
Suppose that a general dentist and three specialty practitioners decide to build a large dental campus where each professional will operate his or her solo practice. Architecturally, the advantages of the common space can be attractive for parking and other amenities.
From a tax and economic perspective, the challenge is to ensure that each practitioner realizes the significant benefits of ownership. From a tax perspective, these benefits are large cost segregation depreciation deductions. From an economic perspective, the benefits are the real estate equity developed during a career in dentistry. Unfortunately, traditional ownership structures sabotage both the tax and economic objectives.
Typically, lawyers and accountants in this situation would form a partnership structure, and have each practitioner own a partnership interest, perhaps in proportion to the space occupied in the building. In our example, this would mean the entire building is owned by a partnership or limited liability corporation of all four practitioners. Each practitioner would enter into a lease between his or her operating dental practice and the building partnership.
From a tax perspective, this form of ownership is a disaster. Let's assume that a cost segregation study identifies $800,000 of building costs that may be depreciated rapidly in a period of five or seven years, instead of the normal 39 years for building depreciation.
Nearly all of these depreciation benefits would be locked up within the partnership, which is a "passive activity." In a passive activity, losses can only offset passive income, not dental practice income. Suppose that, in the first year, the large cost segregation depreciation creates a $150,000 taxable loss in the rental partnership. None of this loss could be used by any of the partners to reduce active practice income.
From an economic perspective, the partnership form of ownership is a disaster as well. Suppose the oldest practitioner is 10 years older than the other dentists and hopes to retire in five years. The building mortgage was secured at attractive interest rates in the current environment.
What happens five years from now? Building partnerships among dentists are an ultra-expensive version of the parlor game, Old Maid. In the parlor game, the objective is to not be holding the Old Maid when a player gets rid of all of his cards.
In the dental real estate partnership, the objective is to have a successful younger partner who will be willing to undergo multiple mortgage refinancings over a number of years in order to buy out the equity of the older partners.
If, in our example, mortgage interest rates have risen dramatically over five years, the remaining partners could be in the untenable situation of having to refinance at higher interest rates to buy out the retiring older partner. From an economic perspective, the partnership form of ownership creates tremendous headaches and risks for each dental practitioner in realizing his or her share of the real estate equity.
A much more elegant form of ownership supports the objectives of each dental practitioner, along with the advantages and amenities of the large common building. This ownership structure would be a condominium arrangement. The planning would involve forming a condominium association that owns and maintains the common areas, along with offering office building condos for each dental practice unit.
Each dental practitioner would own his or her office space. This accomplishes both the tax and economic objectives. From a tax perspective, each practice condo unit could still be owned in a separate LLC and leased to the practice but with the ability to aggregate the large deductions with the dental practice income.
From an economic perspective, each dentist has the ability to sell his or her space to the purchaser of the dental practice without involving an economic disruption to the other dental practitioners in the common space.
In summary, real estate partnerships -- while simple to form and operate -- are toxic to the objective of realizing the income tax and economic benefits of building ownership for dental partners.
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@example.com.
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