Real estate is a popular investment among physicians, but many owners expose themselves to unnecessary lawsuit risks and end up paying far too much in taxes. Here are three smart strategies for lessening those risks and minimizing your tax burden.
Real estate is a very common investment among doctors. However, very few doctors take the proper legal steps to get the most out of their real estate. As a result, doctors expose themselves to unnecessary lawsuit risks and pay far too much in unnecessary taxes on their real estate investments.
This article will show you how to own real estate so that you protect your personal and practice assets from lawsuits against yourself, your family, your partners and your employees. Perhaps most importantly, the proper structure could more than pay for itself through the tax savings you may realize.
The types of real estate we’ll discuss include rental residential or commercial properties, the practice building or even raw land. The merits of real estate as an asset class are numerous, but the structure to most efficiently benefit from these investments is universal.
As all doctors learn in medical school: “First, do no harm.” The same concept can be applied to real estate investing. The last thing you want to do is invest in an asset that generates a lawsuit and the subsequent judgment wipes out all of your other wealth. Each year, millions of lawsuits are filed against real estate owners by tenants, guests, lessees and even trespassers.
Let’s look at an example of a real estate lawsuit risk:
Rob the Real Estate Owner is Victimized
Rob owns a number of apartment buildings, some in his own name and some in his wife’s name. The total value of the real estate is $4 million and there is about $2 million of debt on the properties. The rental income more than covers the debt service, and Rob and his wife make a nice little profit every month. Rob also has a beautiful home worth approximately $1.5 million, with a small mortgage of about $500,000.
After an unfortunate event at one of the properties, Rob was named in a lawsuit. Thought Rob wasn’t on the property at the time of the event, he still ultimately lost a judgment for $3 million. His liability insurance covered $1 million of the loss, but he had to come up with $2 million himself.
This left Rob with a dilemma: Should he sell all of his real estate properties in a fire sale and mortgage his house for the remainder of the settlement, or sell his house and further mortgage his real estate at relatively unattractive loan rates? Either choice would result in a loss of the equity he had built over the last 20 years. In the end, Rob lost his rental properties and his home. Though he didn’t lose his ability to spot a good real estate opportunity, Rob was very uncomfortable going back into real estate after his experience.
What Could Rob Have Done Differently?
If Rob had come to an asset protection specialist, he could have done a few things to protect himself. Here are a few options:
Separate Properties into LLCs. A limited liability company (LLC) is a legal entity that affords both inside-out and outside-in protection. In other words, if you had one LLC for each piece of property, a lawsuit arising from one property could only threaten the equity in the property inside that LLC. The judgment would not extend to the assets in other LLCs. Further, if Rob had been sued personally for an accident, for malpractice or for any other personal claim, the LLC would provide a high level of protection from that lawsuit -- even though Rob and his family own all the shares of the LLC.
Separate LLCs with Management Company. To take the above strategy to the next level, savvy real estate owners use a management company for all of the various real estate LLCs. This technique can provide significant tax and retirement advantages, as the management company can be structured as a different type of tax entity from the LLCs. This allows the owner to get the “best of all worlds” in terms of the taxation of the entities involved. One benefit the management company can provide the doctor investor is to sponsor non-qualified and hybrid retirement plans. These plans can be layered on top of existing retirement plans at the practice level, do not require contributions for employees, can reduce the taxes on real estate generated income, and ultimately can increase retirement income for the owners. The immediate tax benefits could range from $10,000 to $90,000 per year.
Captive Insurance Company. A high-income real estate owner could create a captive insurance company (CIC) to self-insure the properties from various risks. This strategy allows the business to create a multimillion-dollar tax-efficient reserve fund to cover future losses. The same CIC can be used to protect the medical practice from various risks of employee lawsuits, medical-privacy regulation and Medicare audits, and other significant risks. One very important fact about the CIC is that its reserves are protected from all creditors, real estate, patients, employees and personal suits. For medical practices or real estate investors, the annual tax reductions from the proper use of a CIC could be as high as $500,000. These savings could become very valuable if, as many expect, tax rates increase and reimbursements continue to be cut. If your total income from practice and investments exceeds $1 million, you could benefit substantially from the implementation of a CIC.
To wrap up, if you now own significant real estate, or plan to invest in the future, you will want to maximize the protection of your valuable personal and practice assets (not just the real estate) and minimize unnecessary tax liabilities.