Owning real estate through a separate entity yields advantages for your business, but careful planning is necessary.
By Kristina Drzal Houghton, CPA
Do you feel as if your practice is cramped in your current office space? Maybe you are paying rent and wonder if you could pay the same amount and own some equity ten years from now. Before embarking on buying a new or larger space, there are some tax and business considerations you should consider. This article will not discuss investment diversification and the role real estate should play in your portfolio.
Many entrepreneurs have proven that owning the real estate used by their closely held businesses can provide them the advantages of stable rents for their businesses and appreciation for themselves. Many other benefits accrue to the owner of single-tenant commercial real estate, including the ability to employ advantageous tax strategies, an income stream in perpetuity, asset diversification, and control of the property’s tenancy.
Physician practices are no different and often organize a separate entity to purchase an office suite. It is known as self-rental, a term that describes the activity when a taxpayer rents property to his or her own business. This real estate partnership becomes the landlord, and the tenant is the doctors’ medical practice, a separate legal entity.
Placing the newly acquired real estate into a separate entity can be very beneficial for several reasons:
- Ownership does not need to be identical to the practice; owners of the medical practice can pick and choose whether they want to participate; owners do not need to be qualified owners, which is most often the case with professional practices.
- Rental income from real estate is not subject to the self-employment (SE) tax; a lease of real estate to a closely held corporation represents the ability to withdraw funds from the corporation without incurring Federal Insurance Contributions Act (FICA) taxes (i.e., Social Security and Medicare) or SE tax.
- Retaining valuable assets outside a controlled corporation allows the shareholder-lessor to continue to receive a cash flow stream from the corporation in the form of rents or royalties, even though the shareholder is not employed by the corporation. This can allow a portion of the corporate income to flow to a retired shareholder or a shareholder who is uninvolved in the business operations.
- Retaining ownership of real estate outside the corporation avoids the potential for triggering a gain within the corporation upon a distribution or liquidation of the assets. The entity can be formed as an LLC, taxed as a partnership, allowing all tax benefits related to the LLC status apply regardless of the type of entity in which the practice operates.
Take care to not go overboard with trying to reap benefits. Renting property to a closely held C corporation is an effective way to extract wealth from the business in a form other than wages (subject to FICA taxes) or dividends (nondeductible). However, rental payments that are too high in relation to the property’s fair rental value face possible reclassification as constructive dividends or compensation. On the other hand, taxpayers who receive too little or no rent for the use of property by their closely held corporation may find that the IRS, upon examination, determines that there has been constructive receipt of rental income.
Regardless of the ownership and entity structure you feel is right for you, it is strongly urged to have a written lease between the operating and real estate entities. A lease protects both the tenant and the landlord by spelling out the rights and duties of each and would provide uninterrupted tenancy in the event the landlords sell the building.
The new Qualified Business Income (QBI) deduction created by the Tax Cuts and Jobs Act allows the owner of a business to deduct 20% of the qualified income from his taxable income as long as the business is not a C corporation. There are many limitations and rules, of course. One of the most important limitations is on total taxable income. If a taxpayer’s taxable income is below the lower threshold (which is $315,000 for a married taxpayer filing a joint return), he is eligible for the deduction with a few exceptions. One common question is whether or not a rental real estate activity qualifies as a trade or business. The regulations, which the IRS just released, clarify this. If a rental activity rents to a commonly controlled business, then it qualifies as a trade or business for purposes of the QBI deduction. Businesses are commonly controlled if the same person or group of people owns at least 50% of each entity.
One of the limitations for the QBI deduction is for specified service businesses. These are businesses in fields like health, law, consulting, and financial services. Owners of these types of businesses are eligible for the QBI deduction if their taxable income is below the lower threshold ($315,000 for joint returns), but they don’t get a deduction at all if their income is above the upper threshold ($415,000 for joint returns). The deduction is phased out if the taxable income is between the lower and upper thresholds. The new regulations stipulate that if 80% or more of any businesses’ property or services are provided to a specified service business, then that business is part of the specified service business.
Normally, rental income arrangements, such as leasing real estate to a corporation, produce passive income to the extent of any net rental income received by the lessor. Passive rental income can be very valuable to an individual lessor, since it can serve to absorb passive losses from other activities. However, the IRS has issued self-rental property regulations that prohibit using net income from the rental of property to offset other passive losses if the property is rented to a business in which the taxpayer materially participates.
These rules, converting what would otherwise be passive income into non-passive income, apply only if the rental activity produces net income. If the rental activity produces a loss, the loss continues to retain its passive character. The Tax Court upheld the validity of the passive income recharacterization regulations in a 1998 decision.
It may be that your practice has outgrown its space or decided that it wants to have additional locations. The Internal Revenue Code still allows real estate owners to unload appreciated properties while deferring the federal income hit indefinitely by making like-kind exchanges, which are also known as Section 1031 exchanges. With a like-kind exchange, you swap the property you want to unload for another property (the replacement property). You’re allowed to put off paying taxes until you sell the replacement property. Or when you’re ready to unload the replacement property, you can arrange yet another like-kind exchange and continue to defer taxes. The rules surrounding like-kind exchanges are very strict and it is suggested you consult with a tax advisor knowledgeable in this area prior to entering into either a sales transaction or purchase of new property when you might want to consider a like-kind exchange.
Mentioned above is the benefit of a retired partner retaining ownership in a real estate entity beyond retirement. While this can be a great benefit, the decision to allow this can have far reaching implications. For example, retired owners and future owners may have diverse views on the value of fair rent. Therefore, it is extremely important that the operating agreement for the real estate entity contains very specific language regarding when buy outs are required to occur, how the buy out will be calculated and restrictions on ownership transfers.
Owner-occupied commercial real estate provides an opportunity for value creation by providing an entrepreneur the ability to extract additional cash from his or her business in a way that is tax advantageous. A sophisticated entrepreneur can utilize real estate as a specialized vehicle to provide asset diversification, reduce tax liability, offset taxes from other investment sources, and provide the opportunity to leverage and acquire other assets. It is recommended that business owners interested in working towards the goal of owning the real estate associated with their business and rent from themselves should consult their tax adviser to assess the implications and benefits in their own circumstances.
This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.