Your Medical Building and Taxes: Strategy, Cost Segregation, and More
The decision to buy a medical building for your practice is a big one, and one the way that you structure this purchase and approach tax considerations will have a large impact on whether the building is simply a place to practice medicine or a more strategic real estate investment. Many practice owners in our online physician communities and their practice accountants aren’t familiar with the complexities - and potential - of the tax benefits of real estate. As such, they may follow standard deduction schedules that result in significant taxable income from the property. Below, we’ll cover ways to approach buying and depreciating a building to ensure that you’re not leaving tax advantages on the table.
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Your Medical Building May Be a Bigger Tax Deduction Than You Think
Buying the building that houses your medical practice is exciting, but also stressful. Coordinating the cash flow and logistics is hard enough, let alone the tax implications.
You may have put several hundred thousand dollars down between the down payment and closing costs, and that's before considering any future buildout or purchased equipment. The practice is growing, but cash is tight, and you may still owe tax on the cash that is now funding this building purchase. Then your tax person shows you the depreciation schedule, and it says most of the building will be written off over 39 years.
This is typically the point when a cost segregation study becomes interesting. For the uninitiated, a cost segregation study literally "segregates" the "costs" of the building into major depreciable asset classes, some of which may be eligible to be fully depreciated in the current tax year.
Why the study alone isn't enough
As with all things in life, it is never that simple. Being eligible for a deduction does not guarantee deductibility, and there are still a few thresholds to cross.
The opportunity is real, but the study only shows what can be deducted. It does not decide whether that deduction can offset income from the medical practice, or whether accelerating all available depreciation is even the right move in the first place.
To get the optimal result, the following need to work as one cohesive plan:
Ownership of the building
Cost segregation study
Grouping elections
Current-year tax projection
Depreciation elections
Step 1: Building ownership (where is the building legally held?)
Before digging into the cost segregation study and tax deduction logistics, you have to determine where the building will be owned. By yourself personally? By your operating practice entity? By a brand new entity?
The real estate and the medical practice may both be commonly owned, but they have different economics and, more importantly, different legal risk profiles. That is why the building is commonly owned by its own LLC while the medical practice sits in a separate entity. The medical practice then signs a lease and pays rent to the building LLC.
The building LLC should have its own bank account, loan, insurance, books, and tax reporting. Keeping the property separate may provide important legal and financial benefits, which should be coordinated with the attorney, lender, and insurance professionals involved in the transaction.
The tax problem is that the accelerated depreciation belongs to the building activity, while the profit you want to offset is usually sitting in the operating practice. If no one coordinates the building activity with the practice and the individual return, a great cost segregation study can produce a disappointing current tax result. More on this later, but it is important to know you can have both: separate legal entities, but one economic unit for tax deduction purposes.
You spent the cash now, but deductions come later
Let's put some numbers to this. Suppose you buy a medical office building for $1.5 million and put about 20% down, so $300k in cash, with the remaining $1.2 million financed.
First, consider the depreciation schedule without a cost segregation study. There are two main components: the building and the land. The land is likely to be valued at 10% to 25% of the entire purchase, so call it $250k. The rest, a depreciable asset worth $1.25 million, is depreciated over 39 years.
If you're thinking "39 years is a long time," you'd be right. Under this method, you can deduct only about $32k per year. That creates a cash-to-tax deduction mismatch. You just put $300k of cash down but can deduct only $32k. That's roughly equivalent to paying $100k of salaries to your employees and receiving a tax deduction of only $10k. No one should be fine with that, yet I've seen plenty of physicians simply unaware that a better strategy exists.
Step 2: Cost segregation study
The solution is the cost segregation study. A medical office building is not really one asset. Walk through the property and you will find electrical components, cabinetry, flooring, specialty finishes, signage, parking improvements, landscaping, and other items, all with their own tax lives under IRS rules.
A good cost segregation study separates the depreciable building basis into the asset classes the tax law actually supports. Instead of leaving everything in the 39-year building category, the study may identify components that belong in 5-year, 7-year, or 15-year property. Depending on when the property was acquired and placed in service, and the law in effect for that year, some of those components may qualify for bonus depreciation, potentially including a full first-year write-off.
To be clear, the study does not "create" a new deduction. It moves allowable depreciation into earlier years by identifying the proper recovery period for each component.
The goal is straightforward: move as much of the depreciable basis as we can legitimately support into the correct shorter-lived categories. In the right project, that can bring the tax deduction much closer to the cash invested in the building, sometimes exceeding the owner's cash paid at closing. The next phase is putting numbers to the tax form and making sure all of this actually gets deducted.
Step 3: Grouping elections
This article focuses on the straightforward fact pattern in which one physician owns the entire medical practice and the building entity, and the practice occupies the building. It also assumes the medical practice is taxed as a pass-through entity, typically an S corporation, so the practice income and building loss ultimately reach the physician's individual return.
The building LLC is a legitimate self-rental activity. As with most rental properties, however, it is generally treated as passive by default, while your medical practice is a "nonpassive" activity.
When the building LLC reports a large loss after cost segregation, that loss will be suspended as a passive activity loss and can be claimed in the future when you have other passive income. That doesn't help much now. You've just spent a large amount of cash on the building and may still owe tax on the practice's current income. You need a tax deduction today, not at some obscure point in the future.
Thankfully, there is a solution: an election to "group" the self-rental activity with the medical practice as one economic unit.
Grouping does not merge the entities. The building LLC still owns the property, the practice still pays rent, and the bank accounts, books, lease, and legal liability remain separate. Grouping changes only how participation is tested under Section 469.
Here, the same physician owns the practice and the building entity, works in the practice, operates from the building, and uses the property as an integral part of the medical business. If you materially participate in that combined activity, the building loss becomes nonpassive and available to offset current income, subject to the other limitations on the return (namely basis and at-risk).
Step 4: Current tax projection
Once we know the loss can be used, we still need to determine how much depreciation to plan for the current and future years. For that, you'll need a solid current-year tax projection as well as a rough idea of your practice's financial projections for the next few years.
Cost segregation proposals tend to advertise the largest possible first-year deduction, and it's easy to see why: it's the easiest number to market. But we should be more focused on the tax dollars saved than the size of the number on the depreciation schedule.
Step 5: Depreciation elections
The IRS provides various routes to depreciate the assets of your business. You can claim regular depreciation over multiple years, claim additional first-year bonus depreciation, or target a specific number using Section 179. Using a combination of these options alongside the cost segregation study and tax projections, we can increase the relative value of every dollar deducted.
This is possible because the value of a deduction depends on the tax rate it offsets. In simplified terms, a $100,000 deduction used against income taxed at a 12% marginal rate is worth $12,000 of federal tax savings. The same deduction used against income taxed at 37% is worth $37,000. Timing is extremely important.
This matters for a physician starting or expanding a practice. Startup costs, credentialing delays, new employees, and reduced clinical volume can make the expansion year unusually low income, and the practice may become far more profitable once the new location is running. Taking every available dollar of bonus depreciation in the lower-income year may waste some of the deduction's value, especially once practice revenue ramps up.
So we should model the available choices. Those may include claiming bonus depreciation, electing out for a class of property, allowing regular depreciation, or considering Section 179 when the property and leasing structure qualify.
The five parts must work together
To get the optimal result, five parts need to work as one cohesive plan:
Building ownership: Determine who owns the building and practice, which entity receives the rent, whether other owners or tenants are involved, and how the lease is structured.
Cost segregation study: Identify the depreciable basis, qualifying building components, and appropriate recovery period for each asset.
Passive activity grouping: Determine whether the building and medical practice can be grouped so the resulting deduction is currently usable.
Current-year tax projection: Measure the value of the deduction against the physician's expected income, tax brackets, and cash needs.
Depreciation elections: Decide how much depreciation to claim now and how much to preserve for future years.
Each part may involve a separate analysis, but they cannot be separate conversations. A correct cost segregation study can still produce a disappointing result if the ownership, grouping, tax projection, and depreciation elections are not coordinated. Someone needs to own the process from beginning to end.
What going out of order actually costs
The most common failure is a timing problem: you paid for a study and generated a large deduction, but the loss was suspended while tax remained due on the practice income.
Other problems are less obvious:
You may claim all available bonus depreciation in a year when your tax rate is temporarily low.
The grouping disclosure may be missing.
The building activity, practice return, and individual return may not follow the same position.
None of these outcomes means the deduction is gone forever, but each one reduces the current value of the planning and creates additional work later. This is why you should have a tax professional involved before the study is finalized and even before the first return containing the building is filed.
How your accountant may handle the project
An accountant that’s used to working with both private practices and real estate can manage the entire process, from the initial estimate through the tax return. They can also coordinate alongside your chosen cost segregation provider, review the building and practice ownership, determine whether grouping is available and whether the resulting loss is currently usable, model the timing of the depreciation, and prepare the related tax reporting.
The deliverable is not a report showing a large theoretical deduction. It is a coordinated plan for the building, medical practice, and individual return, designed to produce a deduction you can use when it has the most value.
They can also help you answer questions such as:
What if the building has other tenants?
What if the practice or building has multiple owners?
What if you already own the building?
Should you claim all available bonus depreciation?
Can Section 179 produce a better answer?
If you own or are preparing to purchase the building your practice occupies, talk to your accountant. If you need an accountant experienced with working with private practices, consider one of the accountants on our list of accountants for physicians. On your intro call, tell them about the property, ownership structure, and expected timeline so they can review the structure before the cost segregation study is finalized and before the first affected return is filed.
This article is for educational purposes and is not tax or legal advice. Tax results depend on the complete facts, the taxpayer's jurisdiction, and the law in effect for the relevant year.
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