Art Wiederman, CPA

It is important that you use a company that specializes in engineered cost segregation studies if you're looking to use this tax-savings method in your dental practice.

You just finished building your dream dental office: eight treatment rooms and brand-new equipment in a great location. Although it was one of your biggest investments it will bring in new patients, allow you to do the dentistry you want to do and make the balance of your dental career enjoyable.

Now that the office is completed, potential income-tax savings will be on your mind. Hopefully, your CPA knows how a cost segregation study works. Here’s an overview for the uninitiated.

Constructing a dental office requires spending in the following categories: 

• Dental equipment, computer equipment, furniture, and fixtures. Equipment and computers are depreciated over five years. Furnishings are depreciated over seven years. You also have the option of expensing them under Section 179 up to a maximum of $500,000 per year.

• Leasehold improvements (i.e., structure, plumbing, electrical wiring) and the internal structure of the dental office (i.e., carpet, walls, ceilings). Generally, the structural components of a building are depreciable over 39 years. Qualified improvement property is usually depreciable over 15 years.

Upon reviewing the depreciation schedule of a new client, a dental CPA notes leasehold improvements written off over 39 years and that triggers a recommendation that the client consider a cost segregation study.

Cost segregation studies came about in the 1980s. A company called Hospital Corporation of America was advised by its accountants, engineers and attorneys that instead of writing off the cost of the majority of their hospitals over 39 years, the company should come up with a method to “segregate” portions of the construction costs that could be written off over five, seven or 15 years.  

The Internal Revenue Service (IRS) audited Hospital Corporation of America and disallowed the segregation of the costs, taking the company to court. Several times.

The IRS acquiesced, subsequently creating rules regarding exactly how an engineered cost segregation study must be prepared and documented, giving birth to the cost segregation industry.

Cost segregation studies can be used when a tenant builds out an office, or when a dentist builds or buys a new building. They can even be used by a dentist who built an office anytime after 1987 (yes, that’s correct —1987).  

Here’s an example: In 2016, for $1.2 million, the fictional Dr. John Jones purchased a free-standing building, a shell in which he then built a dental office. The project cost him

$2 million, not including the cost of equipment, furnishings or computers. Dr. Jones then set up a separate limited liability company (LLC) to own the building, which then rents the building to the J Corporation, the operator of his practice.

Dr. Jones has a sharp CPA who suggests performing an engineered cost segregation study. Bill Sheridan, principal of Cost Segregation Consultants in San Diego, California, and J. Curt Gautreau, who is a certified cost segregation professional from Baton Rouge, Louisiana, provided the sample you see above of a cost segregation study for a $2 million building.

As you can see, out of the $2 million, which would have normally been depreciated over 39 years, 15.3 percent is depreciated over five years, 4.2 percent over seven years, 8.7 percent over 15 years, and the balance of 71.8 percent over 39 years.  Depending on the situation, this could save tens of thousands of dollars in income tax in the first year.

Had the entire project cost of $2 million (assume this is the cost of the building and improvements, and that land costs were additional) been depreciated over 39 years, the first year’s depreciation deduction would have been $2 million divided by 39, or $51,282.

With the cost segregation study, the amount of depreciation allowed is as follows in year one:

• Of the five-year property ($306,930), Dr. Jones can deduct 50 percent bonus depreciation ($153,465); he can also deduct 20 percent of the remaining $153,465, or $30,693. Total deduction: $184,158.

• Of the seven-year property ($83,927), he can deduct 50 percent bonus depreciation ($41,963); he can also deduct 14.29 percent of the remaining $41,963, or $5,997. Total deduction: $47,960.

Assuming the 15-year property qualifies as a qualified improvement property under Internal Revenue Code Section 168(k)(3), this, too, qualifies for 50 percent bonus depreciation. So, of the $173,233 allocated to 15-year property, Dr. Jones can take $86,617 in bonus depreciation and $8,662 in additional depreciation for a total of $95,279 in year one.

Finally, he receives depreciation on $1,435,910 over 39 years, which comes to $36,818 per year.

So, the total first-year depreciation deduction with the cost segregation study is $364,215, compared with a first-year deduction of $51,282 without a cost segregation study. This gives Dr. Jones an additional depreciation deduction of $312,933, which, at a 40 percent marginal tax rate (federal and state), saves him $125,173 in taxes.

Now let’s assume Dr. Jones built the exact same building in 1999 and has filed tax returns through 2016. Federal tax law states that he can have a study done for his 2017 returns, file the proper paperwork with the IRS, and make a retroactive adjustment to his tax return, called a Section 481(a) adjustment. In 2017, he can take a one-time deduction based on the difference between the depreciation he would have taken had he done the study in 1999 and the amount he has taken without the study.

In this case, had he done the study in 1999, he would by this time have taken all of the depreciation on the five-year property of $306,930; on the seven-year property of $83,927; on the 15-year property of $173,233; and seventeen-thirty-ninths of the $1,435,910 taken over 39 years on the structure, which comes to $625,909. So the total amount of depreciation using the cost segregation study numbers is $1,189,999.

Without the study, he has taken depreciation of seventeen-thirty-ninths multiplied by $2 million, which is $871,795.  So the difference between the $1,189,999 and the $871,795 is the one-time deduction, which comes to $318,204. At a 40 percent marginal tax rate, that is a one-time savings of $127,282.

If you are planning on building a new office, whether it includes the purchase of a building or not, or if you have built one anytime after 1987 and did not do a study, the implementation of a study can save you tens of thousands of tax dollars.

It is important that you use a company that specializes in performing engineered cost segregation studies. In addition, you have until the due date of your tax return including extensions to have the study prepared plus file the required IRS form, Form 3115. 

Finally, if you generate the large depreciation deduction, which throws your Schedule E (this is the form on your personal tax return that will be filed if you own the building in a single-member LLC) into a loss for the year, it is very important that your CPA makes what is called a “grouping election” pursuant to Treasury Regulation Section 1.469-4 on your corporate tax return and on your personal return. This avoids what is called the passive activity loss rules, which would disallow the loss created from the depreciation deduction created by the cost segregation study.  

Be sure to consult your tax professional about this as the rules are very complex.  

Art Wiederman is a CPA and managing partner of 

, a CPA firm that works with about 250 dentists in Tustin, California. He is a frequent lecturer at local, state and national dental meetings and is a founding member of the 

 (ADCPA), which comprises 26 dental CPA firms across the country, servicing more than 9,000 dentists. 

Articles

Here's a way to save tens of thousands of dollars on a new build or renovation of a dental practice: the cost segregation study. Instead of writing off construction costs over 39 years, qualifying construction might be written off over five, seven, or 15 years. Make sure your CPA knows how this key savings opportunity works.

How to Lower Your Taxes on Practice Construction, Renovation

The largest expenditures you will make over your dental career will be the acquisition of fixed assets. Whether you have expanded or are planning to expand your practice, are undertaking a new build, or are purchasing an existing practice, you will spend hundreds of thousands of dollars on equipment, furnishings and leasehold improvements.

One of the most frequent questions dental-specific CPAs are asked is, “We just spent thousands of dollars on new equipment. Can we write off the purchase this year, and how much in taxes will we save?”

The answer is complex. You need to understand how the acquisition of fixed assets is treated under tax law, and specifically, how Internal Revenue Code Section 179 and the rules for bonus depreciation work. Most important, you need to know how to use them to your advantage.

Under federal income tax law, the purchase of fixed assets is subject to depreciation. Dental equipment and computer equipment is depreciated over five years, furniture and fixtures over seven years, qualified leasehold improvements over 15 years, and structural components over 39 years. 

Internal Revenue Code Section 179 allows you to forego depreciating qualifying property over the time periods noted above and allows you to expense these purchases in the current year subject to limits set by Congress.

The PATH Act set the limit for taking deductions for purchase of fixed assets at $500,000 per year and has provided for indexing this amount for inflation. For virtually all of our dental clients, whether single owners or group practices, this limit was more than enough to take care of their annual fixed asset expenditures.

Section 179 property is defined as tangible personal property used in a trade or business that is placed in service during the year.

In a dental practice, this includes dental equipment, computers, furniture and fixtures along with carpeting (there are special rules for carpeting depending on whether it is tacked or glued down) and most dental cabinetry (most dental cabinetry is modular and can be removed and taken elsewhere). In addition, there is a category of assets called qualified leasehold improvements, which also qualify for Section 179. This category involves any improvement to a building’s interior (usually moving and building walls). The building must be nonresidential real estate pursuant to a lease that is occupied by the dentist and the improvement must be placed in service more than three years after the building has been first placed in service. If the dentist owns the building and leases it to his or her own corporation, the improvements do not qualify for Section 179. However, they should qualify as qualified improvement property and will qualify for 50 percent bonus depreciation.

Any assets that are considered structural components of a building, such as the building shell, plumbing and electrical work, will not qualify. Also, if you purchase a vehicle that is under 6,000 pounds, it qualifies, but you are limited to the annual luxury depreciation limits, which are very low. For vehicles that exceed 6,000 pounds, the Section 179 deduction is allowed, however it is limited to $25,000.

Also, you must remember that the asset must be placed in service in the year that you wish to take the deduction. So, for example, say purchased digital X-ray equipment for four operatories for $50,000. Whether you pay for the equipment before the end of the year in full or make a deposit, if the equipment is not installed and in a “state of readiness” then — whether you wrote the check on Dec. 31 or made a deposit – you do not get the deduction. 

On the other hand, if you have the equipment installed on Dec. 28, and you do not pay for it until January of the next year, you can take the Section 179 deduction. 

DOES YOUR BUSINES ENTITY TYPE AFFECT DEDUCTION ELIDGIBILITY?  

Yes it does. You and your tax adviser must note the following:

		For sole proprietors, C-corporations, single member limited liability companies (which are generally taxed like sole proprietorships), and partnerships where the individual doctors or their wholly owned professional corporations are the partners, the rules are liberal. For sole proprietors and single member limited liability corporations (LLCs), as long as you are “at risk” in the investment, which means you either paid cash or took out a bank loan for which you are personally liable, then you get the Section 179 deduction. 

		For general partnerships or LLCs with more than one member, the rules are the same except you have to make sure you have basis in your partnership interest. As a general rule, as a partner, you receive partnership basis for any debt you incur for which you are personally responsible. So, if you borrow $250,000 to purchase dental equipment and you take out a $250,000 loan, you will receive basis in your partnership interest sufficient to take the Section 179 deduction.

		For S-corporations, there is a huge trap for doctors who take out bank financing to purchase fixed assets and who want to take the Section 179 deduction. Say you decide to purchase a cone beam machine in your practice in 2017.  The cost of the machine is $175,000 and you want to write the entire amount off in 2017 because your practice is doing much better than it did in 2016. So, you go to the bank and take out a loan through your S-corporation for $175,000 and you are personally liable for the loan. No problem-right? Unfortunately, not right. There is a concept in tax law called S Corporation basis. It is similar to basis in partnerships and LLCs. As noted above in a partnership or LLC, if you are personally liable (at risk) for the loan, you get the deduction. However, under the S-corporation rules, even though you are personally liable for the loan, you do not get S-corporation basis and you do not get the Section 179 deduction. If you pay off the loan over five years, by paying the principal of the loan, profit is created in your S-corporation which creates basis. How can you get the deduction in the S-corporation? The only ways would be:

		A) You contributed the money personally (by a loan, or preferably a capital contribution) and are paying for the machine yourself or

		B) You are using bank financing, you borrow the money personally from the bank, then contribute the $175,000 in bank proceeds to the corporation. A capital contribution or loan by you to the S-corporation creates S-corporation basis and allows you to take the deduction.

Complicated enough? If you are purchasing any appreciable amount of fixed assets for your dental practice, it is critical that you review the transaction with your certified public accountant prior to completing it. Unfortunately, I have received phone calls in March or April, when a dentist is completing his or her taxes, during which the dentist has said to me, “I was told that if I bought this equipment before the end of the year I could write it off. Now my CPA tells me I can’t and I owe a ton of taxes.”  At that point, my compassionate side kicks in, but beyond that, there is little I can do.

Art Wiederman is a CPA and managing partner of Wiederman and Chamberlain, a CPA firm that works with more than 200 dentists in Tustin, California. He is a frequent lecturer at local, state and national dental meetings and is a founding member of the Academy of Dental CPAs (ADCPA), which comprises 26 dental CPA firms across the country, servicing more than 8,000 dentists. 

You need to understand how the acquisition of fixed assets is treated under tax law, and specifically, how Internal Revenue Code Section 179 and the rules for bonus depreciation work.