Physician practices often find themselves in the real estate business by purchasing the building used by the practice. There are several benefits to owning real estate, but also some pitfalls.
Physician practices often find themselves in the real estate business by purchasing the building used by the practice. There are several benefits to owning real estate, but also some pitfalls to watch out for.
Ownership has benefits
Ownership in the practice building provides control over expenses and the opportunity to realize appreciation in the real estate market while having a dependable tenant—your own practice.
Expenses of operating the rental property, such as real estate taxes and insurance, can be paid by the practice. Rental income in the rental activity can be shielded from tax through depreciation (which allows the owner to deduct the cost of the property over time, thereby sheltering the rents generated currently from tax). This depreciation is recaptured when the property is sold in the future.
Any net rental income received is only taxed for income tax purposes and not payroll taxes—unlike compensation paid within a corporation. Wages earned in a corporation are subject to a combined rate of 7.65% (15.3% for both employer and employee) FICA or 1.45% (2.9% for both) if wages exceed $117,000 in 2014. Net rental income does not have this additional tax.
Why losses matter
Does the rental activity generate income or losses?
There are a few exceptions, but rental activities generally are considered passive. If rental losses are generated within an entity, those losses can only offset income from other passive activities. Therefore, a rental loss cannot offset income or wages from your practice, since this income is derived from an activity in which you materially participate and is considered non-passive.
These rental losses are suspended and used only to reduce other passive income in the future or fully recovered when the rental activity is completely disposed in a taxable transaction. This can still be beneficial if you own other rental activities, either commercial or residential, and they have income.
However, this isn't the case if you have a rental arrangement between a physician and the physician-owned real estate entity, which is considered a "self-rental" activity. In this case, losses are re-characterized as non-passive since the underlying activity is a business in which the owner materially participates. Losses from a self-rental do not offset income from other passive rental activities. If you own other rental activities, separate those activities that are passive rentals and those losses can still offset passive income.
When can you deduct real estate losses currently?
One of the exceptions to characterizing rents as passive is if the taxpayer is a real estate professional. This is a tough hurdle to jump, but if you qualify, then losses from your rental activities can offset other income, such as wages, on your tax return.
The important criteria are: 1) more than 50% of your services (including work you are paid for as a physician or other occupation) must be in the business of renting or leasing real property, and 2) the hours you spend in the real property business must be documented and exceed 750 hours.
A full-time physician would find it difficult to meet these requirements, but a spouse who manages real property or is in the real estate business could qualify.
Protect yourself and the practice first
To provide liability protection, the property should be owned by a separate entity from the practice to insulate risks from the practice and from the rental property. An entity structured as an LLC for the property affords the most flexibility and the most efficient tax structure.
Many physician practices are structured as corporate entities (C Corp.) and have unique challenges. One of the challenges is how income is taxed. There is no distinction between types of income and therefore all income is taxed at one rate—currently 35% for professional practices. This would include the gain from a sale of real property owned in the corporation.
There is also the challenge of "double taxation"—distributions from the corporation are taxed as dividends to the recipient, including gains from the sale of property. A more tax-efficient entity would be a pass-through LLC entity, where gains from real estate are currently taxed at the lowest rates for individuals (15% or 20%) and the "double taxation" of dividends is avoided.
Laws to consider
Physician-owned properties rented by other practitioners that provide items or services to patients of the physician landlord may run afoul of Stark and Anti-Kickback laws. The concern is that the rental arrangement between these entities may be disguised kickbacks or inducements to the physician owners to reciprocate with referrals.
There are specific criteria to follow to provide legitimacy to the rental arrangement. Some of them include: 1) signed written lease or agreement by both parties; 2) an agreement that is not less than one year; and 3) rent charged is set in advance and is a fair rental value in an arms-length transaction (between a willing buyer and willing seller) and not based on volume of business generated by either party.
Lease agreements should be prepared by qualified legal counsel.
Other taxes to consider
The good news is a property considered as "self-rental" is not subject to Medicare surtaxes added with the passage in 2013 of the Patient Protection and Affordable Care Act. This 3.8% tax is added to investment income, including rents, which exceed investment expenses.
However, rents derived in the ordinary course of business such as those for a self-rental between a physician practice and the physician-owned real estate avoid the additional tax.
Kathy Dean-Bradley is the Manager, Tax & Small Business, at Belfint Lyons & Shuman, P.A. in Wilmington, DE. To contact Kathy for more information about BLS services, please email her at KDean-Bradley@belfint.com or call (302) 225-0600.
Belfint Lyons & Shuman, P.A. is a proud member of the National CPA Health Care Advisors Association (HCAA). HCAA is a nationwide network of CPA firms devoted to serving the health care industry. Members provide proactive solutions to the accounting needs of physicians and physician groups. For more information, contact HCAA at info@HCAA.com or visit www.hcaa.com.