A little help from Uncle Sam: Smart deductions on dental office leasehold improvements
As a plan sponsor, are you prepared for the new scrutiny your plan will undergo, beginning this summer?
By J. Haden Werhan, CPA/PFS – Thomas Wirig Doll
Whether building from scratch, freshening up, or relocating your dental office, arranging for new or improved digs is often among the most satisfying accomplishments of a dentist’s professional career – if all goes well. Part of ensuring your dental office improvements are a labor of love and not war is to maximize available tax benefits from the project. After all, the expense is extraordinary, so why not benefit from some extraordinary encouragement from Uncle Sam? This is especially important in light of the current burdensome depreciation rules related to leasehold improvements.
Leasehold Improvement Depreciation: How Slow Can You Go?
There are many components to a new dental office but, for tax purposes, all the components are broken into a few main categories each with their own depreciation write-off rules:
Category ... Length of time the depreciation is typically written off over.
Equipment ... 5 years
Computers ... 5 years (software - over 3 years)
Furniture and Fixtures ... 7 years
Leasehold Improvements ... 39 years
We say “typically” because there are some exceptions. Software is written off over three years. For new dentists who don’t need the faster write-off, I sometimes use seven years for equipment, saving the depreciation deduction for future years. (One client described the longer depreciation as a “slow burn.”) Leasehold improvements used to be treated as 15-year property in recent years, depending on which tax-law stimulus package was applicable. Also, in 2010 and 2011, Section 179 and bonus depreciation (accelerated depreciation methods) were available for certain leasehold improvements. A bonus depreciation of 50% is available on leasehold improvements in 2012, but not in subsequent years.
Exceptions aside, under present law, leasehold improvements are to be treated as 39-year property. That’s a long time no matter how you measure it. Some practices aren’t even in business for that long! Assuming leasehold improvements cost $200,000, the annual depreciation expense using the 39-year recovery period is $8,205.
What can you do to mitigate this burdensome tax treatment of leasehold improvements? Some suggestions follow:
Be Careful With Your Cabinetry
It is not uncommon for a contractor to include cabinetry in leasehold improvements. Cabinetry can (and should) be included in furniture and fixtures, so it can be depreciated over seven years. To avoid lumping cabinetry in with the lengthier, 39-year recovery period for leasehold improvements, I recommend that they be separately invoiced, described as “Specialty Dental Cabinets,” and labeled with serial numbers that appear on the invoice. These steps should protect you during an audit if you are challenged over classifying your cabinets as furniture and fixtures and depreciated accordingly.
Tear Down the Wall of Construction Costs
Ask your contractor to be as detailed as possible in breaking down construction costs to eliminate obvious costs from landing inappropriately in the 39-year category. You’ll be doing yourself and your dental accountant a favor if your breakdowns include:
• Demolition: Removal of access barriers versus general tear-down
• Framing walls: General versus reinforcement for cabinets or X-ray equipment
• Plumbing: Operatories, lab, sterilization, restroom, kitchen, etc.
• Electrical: Operatories, lab, sterilization, restroom, kitchen, etc.
• HVAC: Units, wiring, plumbing
• Flooring: Tile, vinyl, carpet
• Wall covering: Paint, paper, vinyl
• Ceiling: Grating tiles, other
Know Your Tax Codes
Internal Revenue Code Section 190 provides for a current-year deduction of up to $15,000 for expenditures that remove access barriers for disabled individuals. Eligible expenditures include adding ramps, handrails and handicapped restrooms; lowering counter-tops and drinking fountains; and removing similar access barriers.
The Internal Revenue Code Section 44, Disabled Access Credit, is a tax credit for expenditures that remove barriers to and provide access for disabled individuals. The credit is 50% of expenditures between $250 and $10,250, to a maximum of $5,000. It falls under the category of General Business Credits, and can get caught up (suspended) in a dentist’s calculation of AMT (Alternative Minimum Tax). Simply stated, if you are in AMT, you don’t get the credit that year. However, the credit carries forward until used up.
If there’s a silver lining in the cloud of Bush-era tax cuts expiring at year-end 2012, regular income taxes may again begin to exceed one’s AMT starting in 2013, enabling the Disabled Access Credit to be more commonly applicable, as it was in the 1990s. We shall see.
Leverage Your Landlord
When negotiating the premise lease, arrange for your landlord to pay for some of the improvements. Some landlords may offer a credit for improvements and/or a “loan” for improvements in the form of increased rent, which is treated as a current expense. But be very careful with this. You don’t want to pay interest on a loan to the landlord, in addition to a cost of living increase on the rent. A detailed schedule showing the rent and leasehold improvement repayment formula should be agreed to. Assign the landlord any improvements that cannot be moved out of the 39-year category by utilizing the detailed breakdown referred to above.
Crunch Some Numbers: Conduct a Cost Segregation Study
Thanks to The Hospital Corporation of America v. the IRS Commissioner (1997), dentists are able to separate certain personal property from the real property to shorten the depreciable lives of those assets from 39 years to between five and 15 years. These include:
• Plumbing and electrical from the point it enters the premises to the point it is attached to operatory, lab and sterilization equipment. These are treated like an installation expense and capitalized with (added to the cost of) the equipment to which it is attached, thereby enabling it to be classified as five-year property.
• Other assets that clearly don’t have a real useful life of 39 years are reclassified into shorter recovery periods.
• A portion of general contractor expenditures for insurance, clean-up, overhead and profit, etc. should also be reallocated proportionately based on the above.
Illustration: If the cost of leasehold improvements is $200,000 (before the contractor’s overhead, profit and general expenses of $40,000), and an amount of $60,000 (30%) is reallocated from 39 years to five years, then $12,000 (30% of $40,000) should be assigned a five-year recovery period and the remaining $28,000 should be 39-year property – or just work with your specialized tax consultant to sort that out!
Consider a Cost Segregation Study that moves $72,000 out of the 39-year recovery period into a five-year recovery period. The annual depreciation on $72,000 over five years is $14,400, while it would have been $1,846 over 39 years. The difference is $12,554 additional depreciation per year for the first five years. Or, in a 40% tax bracket, that translates to a savings of $5,022 per year for the first five years.
Those savings could be put to good use. Depending on the priorities you and your dental CPA/financial planner have decided upon, that money could go toward debt reduction, college savings, an IRA, or perhaps that long-delayed family vacation. Regardless, it’s clear to see that, with proper planning, those seemingly insignificant numbers and details can add up in a significant way to benefit your dental office as well as your life.
Note: Feel free to contact J. Haden Werhan, CPA/PFS, principal and owner of Thomas Wirig Doll, an accounting and wealth management firm that works with dentists. He can be reached at email@example.com or (877) 939-2500. To read previous installments of Wealth Extractions, please click here.