There comes a time for most physicians when the idea of owning their own office space becomes desirable. Often, this is a result of rent fatigue, which is defined by the involuntary eye roll that occurs when you sign that large rent check to the landlord, or simply of the desire to create something that will produce a positive cash flow for the future. This article will discuss a few tax issues to keep in mind when considering if you’d like to have a little space of your own.
First, who should own the real estate? You personally or your practice? Whether you plan to purchase your existing office space or are planning to purchase raw land and construct your own building, this transaction should be done completely separately from your practice and the practice’s legal entity. This means creating a separate legal entity, typically a limited liability company (LLC), which will be used as the vehicle to purchase the real estate. The LLC should be owned by you (or you and your spouse or business partner(s)) and not by your practice. This is done for several reasons, including considerations for legal liability and tax purposes. The takeaway is that you do not want to co-mingle your practice with what will be a separate business: owning real estate.
Second, what are the tax benefits of purchasing your own space? The asset that is ultimately purchased, whether an existing building or the construction of your own building, will be the primary factor determining the tax benefits derived from the acquisition. Depreciation expense will be taken on the costs of any buildings or structures acquired or constructed. The Internal Revenue Code does not allow for any depreciation to be taken on the cost of land, which should be kept in mind when negotiating a purchase price for an existing structure. For tax purposes, a building’s acquisition cost is typically depreciated over 39 years. Any improvements made to an existing building could be eligible for more immediate depreciation deductions, subject to provisions. Whether you purchase an existing building or construct your own building, it may be advantageous to have a cost segregation study performed to itemize parts and components of the building that could be depreciated over a shorter life (i.e. more depreciation sooner) than that of the statutory 39 years as previously mentioned.
Finally, how do you pay rent and how does that impact your taxes? As you take occupancy of the new space, your practice should pay a fair market rent to the real estate entity, which will be a tax deduction for the practice and rental income to the real estate entity. The real estate entity will typically have deductions, such as depreciation, interest expense, repairs and maintenance, and property taxes to take against the rental income. It is often a good tax plan to have a triple net lease agreement wherein the medical practice pays for expenses such as the property taxes, insurance, utilities, maintenance and repairs of the property. Ultimately, the net income of the real estate entity will be passed down to the owner(s), who will be responsible for the income tax on the profit. In regard to this, the IRS has special rules when it comes to self-rental income — income from real estate activities in which you rent to yourself — that will change the classification, for tax purposes, of the income generated from the real estate activity. You should consult your tax adviser for the impact of this on your particular tax situation. At the end of the day, your previous rent money is now being paid to the new landlord, you!
As can be seen, there are a few considerations to address before making the purchase decision. Ultimately the goal is to create an asset that will not only build value for you in the long run but will also positively contribute to your overall tax and cash flow situation. As an added benefit, just maybe this will reduce the potential eye roll-related injuries as well.
Christopher Davis is a Manager with Sol Schwartz & Associates PC and has been practicing public accounting since 2008. Davis practices in various areas of public accounting, including tax compliance and consulting for individual, corporate, S corporation and partnership taxation. He is a member of the firm’s Healthcare niche that specializes in identifying and implementing solutions to achieve the goals of the physician clientele we serve. You can contact Davis at firstname.lastname@example.org or 210-384-8000, ext. 118.