Strategic tax planning maximized personal tax benefits from building purchase and leasehold improvements.
Overview
A multi-owner, S corporation medical practice purchased an owner-occupied commercial shell for $500,000. The building was purchased under a partnership with ownership matching that of the medical practice. The partners’ intent from the original purchase was to finance the leasehold improvement buildout, which was projected to reach $1,200,000. A major bank provided a construction loan, managed the building process and released funds at various stages of completion. The improvements included soft costs such as architectural, permitting and carrying costs, and hard costs such as a second-floor addition to maximize space, electrical wiring for specialty equipment use and a kitchenette. There were also considerations of costs like furniture and furnishings once the project was complete. All legal guidance was provided by a reputable attorney in the healthcare space.
From the beginning, we understood that the owners were in the dark when it came to this building. Their primary focus at the time was to complete the project in a timely manner. Let’s reveal what planning strategies were implemented to the benefit of the owners.
Tax
Savings
The owners achieved a federal tax deduction of $655,000, translating to
individual tax benefits of
$242,000.
Approach
A key consideration was managing the costs of the building after it was placed into service. Unlike constructing a building from the ground up, purchasing an existing shell and then making improvements requires different strategies. The building, initially purchased and improved, offered limited opportunities for cost segregation due to its structural nature. We focused on accelerated depreciation methods like Section 179 and bonus depreciation for all leasehold improvements. Additionally, due to California’s restrictions, we shortened useful lives where possible to maximize state tax benefits. Carrying costs and soft costs were capitalized and allocated between the building purchase and its improvements. We used a bank-provided project summary to allocate costs and determine useful lives, taking federal bonus depreciation where possible. Despite this tax year’s limit of 60% bonus depreciation, the owners benefited from a $655,000 federal tax deduction, translating to personal tax benefits of $242,000. This was only possible due to industry knowledge.
The empty building had to be furnished. We recommended buying all furniture and furnishings through the medical practice with cash to leverage Section 179, avoiding potential shareholder basis issues. This strategy provided a $30,000 tax benefit compared to financing the costs through the partnership. Additionally, we advised our client to consider a triple-net-lease, whereby the medical practice would pay for most costs associated with the building. Rental payments from the medical practice to the partnership should be at arm’s length (FMV) to service the debt in the partnership. Triple net leases inherently produce lower base rent. Additionally, we find that a lease should add language to suggest all improvements to be paid for by the tenant. In practice, the tenant could cover those improvements in cash and deduct them in full without worrying about depreciation limits at the partnership level. At the time of writing, the spread in depreciation methods is 40%, which is quite substantial.
Covering costs of furniture and furnishings under medical practice versus partnership resulted in
$30,000
of tax benefit.
Tax
Savings
OVERALL IMPORTANCE OF STRATEGIC PLANNING:
- The case underscores the value of strategic tax planning in deferring major tax obligations and maximizing benefits from significant asset purchases.
- Working with a knowledgeable CPA can optimize tax benefits related to high capital investments and complex transactions.