In Part 2 of this series, Wes Read builds on the cost segregation foundation from Part 1 to cover the critical structural decisions every building-owning dentist must get right. He opens with a firm warning against holding your building inside your S-Corporation, walks through the correct two-entity structure, and then dives into passive activity rules — including the often-asked question about qualifying a spouse as a real estate professional.

Key Topics Covered

1. Critical Warning: Never Hold Your Building in Your S-Corp

Wes outlines four major reasons why placing your building inside your dental S-Corporation is one of the most costly mistakes a dentist can make:

• Extraction is a tax nightmare. Pulling real estate out later triggers a taxable distribution at fair market value, potentially creating a $200K-$250K tax bill
• Liability exposure: the building is exposed to malpractice claims and employment disputes inside the operating entity
• Financing complications, lenders underwrite commercial real estate separately; mixing it with operating assets creates problems for refinancing and equity lines
• State licensing compliance  in many states, non-dentists cannot own a dental professional corporation; a separate LLC keeps ownership clean

2. The Right Structure: Two-Entity Strategy

The correct setup involves three layers:

• You (the dentist) file a personal 1040 tax return
• Dental S-Corporation owns the practice, generates clinical revenue, and pays rent to the building LLC
• Real Estate LLC (disregarded, single-member) owns the building, collects rent, deducts mortgage interest and building expenses, and applies cost segregation depreciation

The dental S-Corp pays rent to the real estate LLC. This reduces K-1 taxable income from the dental practice. The rental income in the LLC is then offset by expenses, including mortgage interest, maintenance, and most importantly, cost segregation depreciation.

3. Disregarded LLC Explained

A disregarded LLC provides state-level liability protection but does not exist as a separate entity for federal tax purposes. It files directly on Schedule E, Page 1 of your personal 1040, the lowest-cost, simplest filing structure.

If married, spouses can often be treated as a single member (check your state). If a non-spouse partner is involved, the LLC must file as a partnership — a separate tax return.

4. Passive Activity Rules

Rental income and losses in your building LLC are classified as passive. Key points:

• Passive losses can offset passive income (rent collected) dollar-for-dollar — potentially making rental income tax-free in early years
• Passive losses generally cannot offset W-2 or K-1 income from your dental practice
• Exception: if your AGI is under $100,000, up to $25,000 of passive losses can offset active income
• For owner-operated buildings (you are both tenant and landlord), limitations are stricter

5. The Real Estate Professional Exception

If you or your spouse qualifies as a real estate professional (750+ hours per year, more than any other professional activity), all passive losses from the building LLC can offset any income, including dental W-2 and K-1. This can create a $400K-$500K year-one deduction that nets against dental income.

For most practicing dentists, this is not achievable. However, for dentists with a stay-at-home or non-working spouse, having the spouse obtain a real estate license, manage properties, and log 750+ hours is a legitimate and powerful strategy. This must be well-documented and is audit-sensitive.

Transcript:

Wes Read:  Welcome back everyone to another episode of the Dental Boardroom podcast. So I am carrying on my episodes on what is cost segregation analysis, and, uh, have many doctors brought this up over the years. It is a legitimate strategy, a hundred percent legitimate strategy. However, it's not always the best strategy.

It is. Commonly a great strategy and, uh, and I want you to understand at least the basic, um, terms and definitions and concepts of what a cost segregation analysis is, so you can bring it up with your CPA or financial advisor, many of whom will not volunteer this. It's more work for them, and that extra work doesn't always translate into more income for them.

And a lot of times your financial advisors or your CPS are just so dang busy that they don't get into good strategizing, and this is a good strategy. Okay, what I wanna talk about as we kick off this episode on cost segregation is a critical warning about the building. There have emerged a number of times.

As a prospect comes in and gives me their financials that I learn that they put their building inside of their dental practice entity. Usually an S corporation. They put it inside their S corporation. I cannot tell you how terrible advice they received by whoever recommended that. There are four reasons why I'm gonna state that.

This is an absolute terrible idea to have your dental corporation buy and own your building instead of a separate entity outside of your dental corporation. The first one is extracting your building out of your S corporation is a nightmare. Pulling real estate out of an S corporation later is treated as a taxable distribution at the fair market value of that building.

So let's say 10 years ago you bought your building, you got bad advice or no advice at all, and you thought, well, it's my dental practice. I'm just gonna have one tax id. Maybe I'll save a little bit of tax filing every year by having my my practice entity own my building. The problem is, is that now you're building, uh, your practice has your, your dental office as an asset.

It's checking accounts, it's chairs, it's got your credit card accounts, the, the loans to buy the practice, loans for other things, and then on it, it also has the building as an asset and the building loan as a liability. It's all one. Balance sheet for the doctor. It's one tax id, one balance sheet. And if you go to sell your practice and you don't want to sell your building, well that's a problem.

You have to extract your practice, your building out of your practice. That is, there are various tax reasons why you want these things completely separate. And then if you did that, 10 years goes by and somebody tells you, Hey Doc, you really gotta pull your S corp out now. You gotta bite the bullet. And let's say it's gone up from, you bought it for 1 million, now it's at 1.5 million and you pull it out.

Fair market value is $500,000 more. You probably already depreciated some of it. You're gonna end up paying taxes on that. Of somewhere around five to $700,000 is what I would estimate, and that might end up being 200 to $250,000. Imagine right now I say, Hey Doc, go look in your bank accounts. Go look in your investment accounts.

You gotta come up with $250,000. Yeah, you're gonna say, screw that, Wes, I'm just gonna keep it in my, in my practice. Fine. But you're gonna punt that down the road and you're gonna have to, you're gonna buy that bullet later. So this is why at the onset you absolutely don't want it, your building held in your S corporation.

Uh, alright, so extraction is a tax nightmare. That's number one. Number two is the liability exposure. Having your building inside your operating entity means it's exposed to malpractice employment disputes and litigation. So a separate LLC for your building creates a firewall. Number three, financing complications.

Lenders prefer to underwrite commercial real estate separately. A standalone LLC with its own balance sheet is cleaner. For refinancing or equity lines, banks really prefer to have these two things separate because it is a different type of loan to a dental practice for operations, like buying patient records from someone down the street or buying the practice or buying, um, a, a cadcam and taking out a loan.

Um, they have different underwriting criteria for that than buying a building. Buying a building, for example, they typically want cash down. The building is a collateralized asset where if you buy other things in your practice, they're not really collateralized assets. They're cashflow based assets. And those are two very different types of loans at the bank.

Cashflow based loans versus asset backed loans. And real estate is always an asset backed loan and typically can come with a lower interest rate. So that's number three. It creates financing, complications to own your building inside of your dental S corporation. And number four, state licensing compliance.

In many states, non dentists cannot own a dental professional corporation. Keeping real estate in a separate LLC keeps ownership clean and compliant. So if you wanna go sell your building later, uh, to somebody who is not a dentist, and if the building is held inside of your corporation. That can become quite complicated.

Keep it in your LLC. It makes it so much cleaner from a state licensing and selling standpoint. Alright, so the right answer, a single member LLC that holds only the real estate. Clean, simple, defensible. Now, if you are married. I often will have a spouse on that LLC as well. Not required, but let's say your spouse is a dentist.

This is not uncommon at all in dentistry. And you're married and maybe you're in a, a community property status as many are, and you own that LLC together, uh, that holds the building. You can still call that essentially what's called a single member LLC, because the spouses can be treated as one person.

Not all states allow this, like why doesn't I know offhand. So you gotta speak with a, an attorney to determine, and you can I'm sure, ai this does your state allow, uh, spouses to own an LLCA dis what's called a disregarded LLC and be treated as if they're one person? 'cause as soon as it's two people. Then the iris does not allow you to hold it as what's called a disregarded LLC.

You have to hold it as a partnership and that creates a lot more complications. If you actually have a dental partner or somebody else who owns the building with you, that is not your spouse, then inevitably you want to be a partnership an LLC that files as a partnership. Now you're probably a little bit confused because I didn't clarify one thing.

What is a disregarded LLCA disregarded LLC. Is an LLC that files as if the IT files a tax return as if the LLC structure never existed. You heard me say on my last episode on many episodes that LLCs do not exist to the IRS. You cannot file an LLC tax return. Doesn't exist. The LLC has to decide when it files a tax return.

Is it gonna file directly as if owned by the owner of the building directly in his or her name with his or her social security number? Or is it gonna file as a partnership with a separate tax id or is it gonna file as a corporation, which you don't wanna do here. So a disregarded LLC is simply an LLC that at the state level, protects you from liability.

That's good. But at the federal level, it doesn't exist, and you have to file it directly. This is what I always recommend directly on your 10 40 personal tax return, what's called Schedule E, page one, schedule E, page one. And it therefore, um, that has the lowest cost associated with it. 'cause it's, it's, it's marginal extra work on the 10 40 tax return as long as good accounting is done for that LLC, it's marginal extra work, meaning it is, it's pretty low work to file the income and expenses of your building LLC, directly on your 10 40 tax return if it's not disregarded.

And therefore it's filing as a partnership or a corporation. You have a whole separate tax return and now it goes on Schedule E, page two. Page two is where all your K one income comes from. That's your S corporation for your dental practice or any other type of entity that is an S corporation or a partnership that flows its profits through to you on your 10 40 and doesn't file its own tax return and pay taxes on that separately.

So, um, disregarded. LLC, that is the operative word. Those are the operative words there. You want to be a single member disregarded, LLC, that owns your building whenever and wherever possible. I can't emphasize that enough. Okay, let's now go on to now we've outlined the critical warnings here of, of never holding your building inside your S corporation.

Let's go on to segment five. And again, if you're watching this on YouTube, you will see, uh, a diagram on my screen and I will narrate this diagram. This is a two entity strategy and the structure that works. It looks like this. On the top is a box and it says the dentist. That's you. And underneath it, it says the personal return.

You as an individual have to file a 10 40 tax return. The only time you don't have to file a 10 40 tax return is when your income is so low that you owe no taxes, zero taxes. And so if your income was $5,000 for the year, guess what? You're not gonna have to pay any taxes on that, and therefore you don't even need to file a tax return.

Now, most people had remitted some taxes on their W2, so they file anyways to try to get their money back. Get a refund. But you, uh, if you're a dentist and you're anywhere in a, in a modestly profitable place, you are absolutely 100% gonna have to file a 10 40 tax return. It goes without saying. Now, on the bottom left is your S corporation, your dental S corporation.

This owns the operating entity known as your dental practice. This generates all clinical revenue. It pays expenses, labs, labor supply, facility, marketing, admin in the facility category of rent. You have rent and if you don't own your building, that's going to some dude out there who owns the building and is building their own net worth.

For you. It's a tax deductible expense, but it's not building any wealth for you to do that. If you own your building, then great. You're paying rent to yourself. That's awesome. And this Dental S corporation also then issues you a K one at the end of the year. And the K one shows the net profits to your dental practice after all expenses, what's left?

And that goes out on your personal 10 40 in the box above, and that's where you recognize that as taxable income. Now on the right hand side, you have the real estate, LLC. This is the disregarded LLC. This owns the building. It collects rent from your S corporation. It deducts mortgage interest and other expenses for the building.

And this is where you could do a cost segregation depreciation analysis to shelter rental income. Now these two boxes on the bottom, on the bottom left is your, your dental S Corp. On the bottom right is your real estate. They have a relationship and the relationship is the dental S-Corp pays rent. Over to the rental, uh, to the real estate LLC and the real estate.

LLC has a lease signed by you, the tenant from your S corporation. Your S corporation is the tenant, not you personally. Your S corporation is the tenant of the building, paying that rent to the LLC, the rent that reduces and this rent that it goes from your S corp to your LLC. This reduces your K one from your S corporation.

Because more rent is more expense. More expense means lower profit. Lower profit means lower K one taxable income that flows up to your 10 40 tax return. So now the thing is though, is if your rent, let's say it's a hundred thousand dollars, goes to your real estate LLC, you get a hundred thousand dollars deduction on your S corporation.

And your K one goes down by a hundred thousand dollars and you pay taxes on a hundred less, on a hundred thousand dollars less than if you didn't pay rent. That's good. You may have saved 30, $40,000 right there because of rent expense. However, the money goes over to your rental real estate, LLC, and you have a hundred thousand dollars of income over there.

And these things are just a teeter-totter. More rent from your dental practice, um, means a, a lower taxable income. It also means higher income in your real estate, LLC, and you have to pay taxes on income in your real estate, LLC, in the same way that you pay taxes coming out of your dental corporation. So you're gonna ask, well, how is it really benefiting me?

Me then if I get a hundred thousand dollars deduction in rent in my dental corporation, but I have to recognize a hundred thousand dollars of income in my real estate, LLC. Well, the reason why is 'cause you have all these expenses in your real estate, LLC, that get to reduce or erode that a hundred thousand dollars of income, potentially bringing it down to zero or even into the negative territory.

What are some of your expenses? Well, you have mortgage interest. You have maybe there's certain other expenses. Maybe, maybe you're, you're doing a, a rebuild on the roof or you're painting walls. Now a lot of the maintenance stuff can and should be paid out of your s corporation as the tenant. And leases will identify what does the landlord pay and what does the tenant pay?

And a lot of the smaller stuff is paid by the tenant. That's your S corporation. But there are bigger things like maybe getting a new HVAC system that is paid out of the real estate LLC. Now, this is where you really get the benefit, is you do a cost segregation analysis and you pump up the depreciation.

You front load that depreciation such that a hundred percent of that a hundred thousand dollars of dental, of rental income gets reduced down to zero and even creates that loss I talked about. That's the strategy there. Alright, let's look at, let's look at a under I, I wanna get to an example here shortly, but before we do, 'cause one of the things I bet you're asking is, well, how much can we get away with, how much rent can I pay for my corporation to my billing LLC in order to maximize?

My tax benefits. I mean, if you're telling me, Wes, that I get to deduct 400,000 to 500,000 in my $2 million building in year one, if I do a cost eg paired up with a bonus depreciation, why don't I just jack my rent all the way up to four or 500,000? Well, that's a good question and I'm gonna address that here shortly, either in this episode or a subsequent episode.

But before I do, I just want to cover the landscape of. These, um, various concepts related to this so that I can then get to that crystal clear example and discussion of how much you can jack up your rent to take advantage of this strategy. Alright, I want to, uh, you to understand a, uh, one of the constraints here in segment five of this is understanding passive activity rules.

Passive activity rules. This is getting a little bit into tax 2 0 1 from 1 0 1, so try to follow me on this. Again, I'm not trying to make you a tax CPA, I'm trying to make you an intelligent financial business owner. That's what I'm trying to do, and my belief is every CEO needs to understand enough in each of the modules of their business to make intelligent decisions in each of them and across them.

Intelligence in marketing, intelligence and practice management, intelligence in billing, intelligence in finance and accounting, and intelligence in investing. Again, you don't need to understand a hundred percent of it, but I'd like you to understand like 20% of it so you can understand these concepts because you gotta, most of you gotta go to A CPA who's not gonna do the work of creating a comprehensive plan.

Because CPAs are siloed in their tax area and their accounting area, and that's it. They're not, they're not specialists in cost segregation. They're not specialists in 4 0 1 Ks. They're not specialists in retirement planning, in budgeting and personal finance. They're not specialists in all those categories.

And then you have people who specialize in some of those who don't understand accounting and attacks. And that disjointedness creates massive complications for doctors, and it's one of the. Biggest reasons why doctors don't get ahead financially. Hence the reason why I started practice CFO. I only work with dentists so that we can cover the landscape and be specialist in these uh, areas.

Unique to a dental practice, I don't need to know all the areas of the tax codes for telecom, telecom company, or farming or manufacturing company. No, I don't need, I don't need to. I only need to know all the years of the tax code across a broader spectrum that relate to one specific type of business. A private healthcare practice owner, IE in this case a dentist.

We do have a few medical doctors, but we are 95% dental. Alright, so now with that sort of backdrop in mind of why I want you to stay plugged in here to this episode and understand what are passive activity rules, passive uh, uh, activities, rules are the falling. Your income and expenses are classified as active or as passive.

Now this can get complicated, but again, I just want you to understand kind of the, the highlights, passive losses, LLC rental losses. When you buy your building and you own your LLC that owns the building, these are called passive and they can only offset other passive income. But, and this is an important, but they offset the passive rental income dollar for dollar.

So the rent you collect in your building LLC can be tax free at the LLC level in the early years if you have that ability to deduct that rental income. So the rental income coming in from your dental practice is called passive income and the net income. Or the expenses in your LLC are passive expenses, so they offset each other.

They offset each other. However, you cannot use any losses in your building, LLC net losses for the year to offset your W2 from your dental corporation or to offset your K one from your dental corporation. It can't even be used if you are owner operated, meaning that you are, are, are the one in. The space, you as a dentist are the tenant and the landlord.

That's called owner operated, uh, uh, building. You cannot use your passive losses from that building, LLC to reduce other passive income outside of it. Like let's say you own a real estate property down the street that you don't. Operate in it's, it's a third party renter and let's say that one has net income.

You can't offset your building, your dental building losses against that third party rental income. You're not allowed to do that because you are the an owner operated. You are the, the, the tenant in the building that is receiving the rent from your dental practice. And so there's some limitations there, but the key thing here is any rent you pay from your s corporation to your building, you can offset that rental income by any expenses in your, uh, building LLC.

Now, there's one caveat to that. If your adjusted gross income, your tax, it's not quite your taxable income, it's close to it. If your adjusted gross income is under a hundred thousand. You actually can deduct $25,000 of losses in your building LLC against your W2 and K one income from your dental corporation.

Now, since the vast majority of you, and I hope all of you are, you have income over a hundred thousand 'cause I don't know how you'd make ends meet with your student loans and all the life and toil and blood, sweat, and tears you put into buying, getting your dental degree and buying a practice. I certainly hoped you're above a hundred thousand dollars of taxable income.

Okay, so I'm gonna say for most of you, this little caveat does not apply. Here's the caveat that I find very interesting, and I've had many doctors ask about this. Okay. What if I could classify myself as a real estate professional? This is a, this is a specific term in the IRS tax code that says real estate professionals.

Who do real estate management for their living? It's their job. It's the primary way that they source their, their, their gainful employment is their real estate professionals. They may be a broker, they may be an agent, but they spend, uh, at least 750 hours a year. And they, that seven 50 hours is more than any other professional thing that they do.

They can be considered a real estate professional. And if that's the case, all of the losses in your building, LLC, a hundred percent of them can be used to offset as much other W2 and K one from wherever. And net those two. It is. So if you do a cost eg, and you pair that up with bonus depreciation and you have four or $500,000 in year one of a deduction, and let's say you have a $500,000 W2 from your corporation, this is just a hypothetical, you could net those two and not pay any taxes in that year.

So a lot of you're gonna say, well, why don't I do this? Well, I'm gonna emphasize what I just said a moment ago. You have to spend a seven 50 hours a year and you have to do that real estate work more than your dentistry. Which is why the vast majority, pretty much all of you are not gonna get this unless you have an S Corporation dental practice that is a hundred percent run by associates, and therefore you literally spend your primary job is managing real estate properties.

Then you could take your losses from those real estate properties and offset your S Corporation income. But again, that's extremely rare and it's extremely difficult to have a hundred percent associate run dental practices. Very, very, very difficult. I almost never ever see that. A successful strategy.

Now, here's where it could get interesting. You have a stay at home spouse. They get their real estate agent's license. Very easy to do and they don't actually have to have their real estate agent license, but it sure does substantiate 'cause this very much could get audited. It could substantiate the, uh, the truth or the reality that your spouse is acting as a real estate professional.

And if they can get, if they spend more than seven 50 hours a year, and it's their primary way of sourcing income. Let's say you have a few real estate properties, maybe some are Airbnb properties, and maybe you're not paying a, a management company because your spouse is dealing with maintenance calls and vacancies and collecting rent and the accounting and all that stuff.

Now, that is a real estate professional, and because you're married, you can then offset income from the dental practice by the losses of your building. LLC. And it is a huge win-win. I mean, it is a massive win-win. Now, I will say one caveat is to make sure to talk to your CPA and your state. Make sure your state allows this as well.

There's certain caveats by state, I believe. So talk to your CPA about your specific passive activity position before building this strategy out. This is not a. Do it at home on your own type of strategy. Trust me, pay for some guidance on this one before you execute a plan. So I want you to understand what passive activities, what passive activity is in your billing.

LLC is a passive activity entity and therefore it limits how much of a loss you can deduct on your personal tax return, with the exception of those two caveats I just mentioned, the under a GIA hundred thousand and a more advanced spouse as a real estate professional. Alright with that one everyone, I'm going to wrap up this episode where we talked about the, uh, the warnings of not holding your building in your S corp.

The structure that makes sense between you as an individual, your Dental S corporation, and your real estate, LLC, and then lastly, understanding passive activity rules that may limit the benefits of doing this. Stay tuned for the next episode when we'll get into a more specific example and what rent might be reasonable for you to pay to maximize the benefits of this strategy.

Thanks for joining everybody. Until next time.