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In Part 3 of the Cost Segregation series, Wes Read shifts from theory to execution. He walks through the five concrete implementation steps every dentist must follow to set up the strategy correctly, runs a detailed numerical example showing exactly how the money flows between the dental S-Corp and the real estate LLC, covers how to determine the right rent amount without triggering IRS scrutiny, and closes with three options dentists should consider when it comes time to retire and decide what to do with the building.
Wes lays out the exact sequence for setting up cost segregation correctly:
Using a dentist collecting $1.2M per year:
The IRS requires rent to be at fair market value. Inflating rent to absorb 100% of cost segregation depreciation is a red flag and can result in full disallowance of the deduction plus penalties. Wes advises:
When it's time to hang up the drill, dentists who own their building have three paths:
Wes Read: And welcome back everyone for another episode as I continue on this saga about the cost segregation analysis as a tax strategy for those dentists who own their building and want to be educated on what this strategy is. In this episode, I'm gonna talk about how to implement this correctly, and then I'm gonna talk about how the numbers flow exactly.
And we'll run through an example. Okay, so this is segment six for those of you watching on YouTube. For those of you not on your phone and are watching it on your phone, I will narrate this for you and a little plugin favor for me. If you could subscribe to YouTube and to. My, uh, podcast on your podcasting app, that would be fantastic.
You'd be doing me the honors, put a lot of time and prep into these. Yeah, I do use AI to help curate some of the content, but I always spend quite a bit of time taking that content, organizing it, and making sure it is distributed here to you on this podcast, and hopefully a way that is digestible to understand now some of these contexts.
Concepts around, uh, accounting and cost segregation and passive activity and depreciation and bonus deductions. It can get a little bit complicated, but again, I really want you to listen once, twice, three times if needed, to understand what these concepts are. So that you can bring them up with your advisors and speak edu in, in an educated way about them.
They're the specialists, but sometimes you gotta be the one to, to, uh, to spur on the conversation and to navigate it, because nobody's gonna care about your finances as much as you do. I, I will say here at Practice CFO, we care an awfully lot. It is why we come in. It is a huge part of our beating heart here of our mission statement.
It is because we care so much. At the end of the day, this is your hard earned money. And so you gotta take point on, um, moving along the analytical and strategy discussions with your advisors. Okay, implementation, how to do this cost segregation, right? Number one. So let's say you're about to buy your building.
Or you're about to buy the building and then start the build out. If you're a startup or you're relocating and you're, you're taking it from a shell to an operating dental office, step number one is form the LLC first. The LLC must be the purchaser of the deed. Form it before closing, not after. Now, if you do it after, you can transfer the building into the LLC, uh, and you'll need to talk to the right type of attorney to do that, but I don't recommend.
Buying, uh, the, uh, building first and then forming the LLC, so form the l ls c extremely easy. You literally could go on legal zoom to do it and pay a modest amount. That said, look, you're a high income earner. If you're a practice own doctor, ideally you're collecting north of a million. Ideally, if you, if you're a client of practice, CFO, we want you north of 1.5 and really cranking it.
And if you are, you're in a high tax bracket, look, you wanna don't try to go cheap. You wanna hire people who are gonna advise you. Well, I would spend a lot more time doing due diligence on who your roster of advisors is, but I would. And yeah, this may sound self-serving because I'm an advisor and I want our, our doctors to, to engage us.
I believe strongly that the net effect is they're gonna be better off by having good advisors with us or somebody else. But if they have a roster of really good advisors, I think dentists are gonna be better off financially. Now, when it comes to the strategy of. A cost segregation analysis. You wanna make sure that you've got a good CPA and a good cost segregation company that's working together and a good attorney to make sure that your LLC is set up properly, the lease agreement is set up properly, you buy the building in the right order and that the tax and accounting is done correctly on this.
So one of the most important things wealthy people do, at least really intelligent, wealthy people do, is they surround themselves by very educated people. They get educated. The person gets educated enough to communicate across those different spheres and to organize an overall plan. So step one, form the LLC first, not after step two, close on the building.
The LLC obtains its own mortgage and you personally guarantee it. That is typically the case. Now what does that mean that you personally guarantee it is if you default on the loan that you got out, that you took out to buy the building? The bank can come after your personal assets. They can force you to sell your house.
They can force you to sell your cars. They may force you to liquidate some stocks and bonds. They can't come after your IRAs and 4 0 1 ks and other protected retirement assets like that. But they can come after a lot and don't get scared. That's very, very normal for banks to require that, and that should not dissuade you from if the purchase price is reasonable to buy your building.
All right, so that's step number two, close on the building. Step number three, commission the cost segregation study. So that's where you will find a company, a qualified, usually an engineering firm. This is typically not your general CPA. For example, we here at Practice CFO, don't do cost segregation analysis, analysis.
It requires the engineering a person to go and look at the plans of the building. And to go through room by room and allocate out everything that you bought that you can touch into different categories. So it's not all in just that 39 year asset category. 'cause that is the slowest. Uh, accretion of tax benefit to your tax returns possible.
You want to push those forward, tore them earlier in your ownership life of that building, and that's what the cost said can do it. And so you do need the right type of firm to do this correctly. Again, that's gonna cost about 15 to $25,000 maybe, maybe 10 to $25,000. I care less about the cost in that sort of range.
I care way more that it's somebody who's good and it's gonna go and really dissect that out well and push more of the building, uh, tangibles into the other shorter term asset buckets. Of five, seven, and 15 years. Okay, so that's number three. Commission the cost segregation study number four. So now you've got your LLC in place.
You bought the building, you've engaged the cost segregation study. They've, they've done the analysis now, uh, and they've given you the report that says, oh, how you can break out the purchase price of the building between those different categories for depreciation purposes. And now step four is execute the lease agreement.
And this should be a formal written arms length lease agreement between the S corp that owns the dental practice and the LLC that owns the building. And you should get a market rent analysis from a commercial real estate broker. Again, pay a little bit of money to get something that you can file away and, and that will back your decision on what your rent is.
That if the under an IRS audit, you can point and say, look, I paid this company. They're professionals. This is what they do. To do a EG analysis and here's their, their report and I followed what they counseled me to do. And here is a rent agreement from a real estate professional and a lawyer who put this together with an arm, with an arm lengths lease between the s the S corp and the LLC, uh, to determine what that rent is and the terms of that lit lease agreement.
You can point to that. And that way you are protecting your booty on this and you need to do that. Again, don't try to do this one at home because you're not, you're not gonna have these formal reports by formal professionals that you could point to in the event of an audit. And that can take something that should be a wonderful tax strategy to something that can haunt you for many years.
Because once on the IRS radar, always on the IRS radar, and they will typically not just audit the one year, they will then go and audit. Subsequent years or even years before that, depending on the statute of limitation. So number four, execute the lease agreement with the help of professionals. Now, what should that lease, uh, rate be?
Well, I'll talk about that here in a second. Alright, and lastly, number five, keep clean books have, I cannot emphasize this. Have separate bank accounts for the LLC owning the building, the disregarded LLC, and a separate bank account for your S corp checking account. You should also have a credit card for your S corporation.
I wouldn't necessarily say you need a credit card for the billing LLC, there's typically not that many TRA transactions because most of the transactions with maintenance and upkeep are actually paid by the tenant. They're paid by your S corporation and those you absolutely can put on your credit card were allowed.
Some doctors will still get a separate credit card for the building if there are certain things that they can buy or want to buy on credit card. That should be inside of the building, LLC. But again, the billing LLC doesn't have many transactions. Once you buy it, you're paying your rent. And then every once in a while, if you have a big transaction, like you have to buy a new HVAC or something big that the, that the landlord will typically pay for, then you could have a credit card for that.
But generally speaking, you may be even taking out a loan for some of those things. So don't complicate your life with extra checking accounts and credit card accounts. Only get what you need. And I typically recommend simply a checking account for your building. LLC. Remember, every account checking a credit card account you have.
Has to have in your accounting files like QuickBooks, a separate general ledger account, and it needs to feed in the transactions and categorize those transactions and reconcile back to the bank and post to your financial statements. And guess what? CPAs typically will charge more when you have a lot more credit card accounts because it's a lot more work.
And so keep it simple. Keep it clean. Keep your a separate Chinese wall between your building, LLC, and the the practice. Okay? To reiterate those, number one, form your LLC first. Number two, CL close on the building. Buy the building. Number three, commission the cost segment analysis. Number four, execute the lease agreement.
And number five, keep clean books. Alright, let's look at some numbers here, how the numbers flow. Uh, for those of you watching on YouTube, on the left is your Dental S corporation, and on the right is your real estate, LLC, and I'm gonna go through the very sandwiched version of the Dental S Corp. Number one, your collections at 1.2 million collections.
That's in my example here. Then all your clinical expenses except for your rent, so your labor, labs, supplies, marketing and administration expenses. Equal 600,000. So now you're left with 600,000. Now you've decided that you're gonna pay rent to the tune of 170,000 per year, which is 14,166. $14,167 per month.
Now, is that a going rate? I don't know. That depends on where you are. If you are in. Beautiful La Jolla, San Diego, down the street here about 10 miles away from me. Your rent is going to be different than you. If you are in some, uh, small island in Alaska servicing a set of islands, your rent's probably gonna be next to nothing up there.
And so what your market rate rent should be a function. Of market rates, and that's why you hire a real estate professional to help you with that. And so once you, uh, take that out, you're left with a net income to your s corporation of 430,000. That's 1.2 million in collections, less 600,000 in clinical expenses, less 170,000 in rent equals 430,000 net K one to the dentist.
Now you may pay yourself of that 430,000. 200,000 as a W2 and 230,000 is flow through K one profit. Those two are just teeter totters from each other and should be a function of tax planning. But that's a entirely different episode. So your net income in your corporation before paying you a W2 or your take home, uh, sort of transfer K one, that's 430,000.
Now on the right side of the screen, your real estate, LLC, your rent is what? Well, it's the 170,000. Now what do you get to deduct? If you get to deduct mortgage, and maybe there's a few other costs in there, maybe there's some cam cost, cost of area maintenance or a few other costs. Typically those are pushed down to the tenant though, so there's really not a lot of costs.
Your biggest cost is gonna be the interest on the loan. Remember, the principle is not tax deductible, only the interest. So in this case, let's say you paid in the year $200,000 in loan payments, you may have got $80,000 of interest on that. That is tax deductible. So if that was your only expense, you're paying taxes on $90,000 of income.
That's $170,000 of rent collected less. 80,000 of mortgage interest is $90,000, and that goes on your 10 40 tax return. And it's taxed at ordinary tax rates just like your W2 and just like your K one from your corporation. So if you got $170,000 tax deduction in your corporation and um, but you had to recognize $90,000 of income in your real estate, LLC.
That is therefore 170 less 90,000. That is $80,000 of taxable income that you're still paying taxes on now. So how do you reduce that? Come. What comes in then is depreciation. And if you do that cost segregation analysis, and let's say in year one, you're able to deduct $200,000 of depreciation because of that cost segregation analysis.
Now, normally it might've been, I don't know, 40 or $50,000, but now you're at $200,000. It because of the cost segregation analysis, you actually now ran a loss in that LLC of $110,000. That's $170,000 of rent collected income in your building, LLC. Less $80,000 of interest, less $200,000 of cost segregation deduction.
That's a loss of 110,000. So now in your S corporation, you get a full deduction of the $170,000 of rent paid to your LLC. And because of the cost segregation, you've uh, completely wiped out all of that $170,000 of income. And so now you're paying no taxes from the real estate LLC zero, and in fact, you have this loss of 110,000.
Now if your spouse. If you listen to my prior episode, if your spouse is a real estate professional and works in real estate more than 750 hours, guess what? You could take that a hundred, that $10,000 loss in your real estate LLC, and reduce the $430,000 of income from your dental practice. That is possibly the most beautiful scenario I can think of when it comes to this strategy of owning your building and doing a cost segregation analysis.
It is absolutely beautiful. Uh, and by the way, and I'm gonna go into this a little bit later, later, you could 10 31 exchange your real estate, your building into a bigger LLC property, and then you can do another cost segregation on, on that, and then accelerate more deduction and do the same thing over and over and over.
And honestly, this is what some of the wealthiest people in this country do. They, they layer in 10 31 exchange into bigger and bigger and bigger and bigger properties, frontloading all the depreciation, using it to offset older properties or other income, and then they'll borrow off the equity of the real estate, which is not tax deductible.
So that all is how a lot of people completely get around the tax law. And I think in time legislation is gonna plug some of those loopholes, but that happens. Okay? So the net result is the 170,000 of rent lowers your K one from your S corporation. And the LLC pays no taxes. The rent is effectively tax free income to you.
And that is a beautiful thing. Um, now I wanna go into. What should that rent be for a minute. This is a key point. The IRS knows that this can be manipulated and the IRS will say that the rent should be a market value, reasonable rent, because we are incentivized. Jack your rent up theoretically to the entire amount that would absorb a hundred percent of your cost segregation depreciation in year one in your real estate, LLC.
So in the example that I just showed you, that's still on the screen, that $110,000 loss, that's in your real estate, LLC, if you bumped up your rent by $110,000 to $280,000. Up from one 70, then you would absorb the full cost segregation depreciation of $200,000, and that would thereby essentially give you $280,000 of tax free income into your LLC as rent from your S Corporation.
$200,000 of rental expense fully deducted in your S corporation. A hundred percent tax deductible in the real estate LLC, but it becomes a hundred percent tax free because of the mortgage interest, and then the $200,000 cost segregation depreciation, and you're absorbing a hundred percent of that $200,000 rent.
Now the IRS may come in and say, whoa, whoa, whoa. $280,000 rent. What is that per month? Two 80 divided by 12. That's $23,000 a month, doc. Hey, you got a 1800 square foot? Place in Podunk, I don't know, Nebraska. There is no way that the market rate on that thing is 22,000 whatever per month. You clearly are manipulating the system.
We are going to disallowed it. Not only are we gonna disallow it, we're not gonna give you any tax deduction as a form of penalty on that. So again, like your W2 paid to yourself and your corporation, you need to be reasonable here now. Real estate professionals are well aware of this, just like we CPAs are well aware of what your W2 could be.
And so you can stretch this and so again, you want it using my favorite concept here. Toe the line, not cross the line. So ask your real estate professional to give you as high of a market rate possible. What is the highest rate that you could justify at. Maybe look at higher end buildings down the street.
I don't know a cherry pick which market comps you want to use. I'm not a real estate professional, so I don't wanna speak for them, but there are things that they can absolutely do to migrate up what is a reasonable rate rent to maximize the amount of rent you can pay from your Dental S corporation to your real estate property.
So that's the bottom line there. Talk to a real estate professional, tell them you're about the strategy here and that you wanna optimize this. Maybe even get two real estate professionals who will come in and take the higher of the two, and then hire a dental attor or a, a real estate attorney to memorialize that rate in a lease agreement between your Dental S corporation and your real estate.
LLC. Okay. Options when you retire. I'm moving on now to segment eight. Entirely different SEC section. Alright. You bought your building many years ago. You're now ready to retire. You're in your mid fifties to 70, early seventies, and you're ready to hang up the hat. You've done your financial plan. You've got enough capital such that you could live off between that and social security and any other sources of income that you don't need to work anymore.
You've done the analysis of what your take home will be, uh, upon selling your practice, uh, and after taxes and debt and selling costs, you are financially comfortable. That you can now pivot into retirement. And by the way, practice orbit is free to log in. Use the price assessment on the bottom left of your My dashboard, get your last year's business tax return.
Take 30 seconds, fill it out, and you'll have a good idea of what you could sell your practice for and what you'll take home after taxes and selling expenses and debt. It's a beautiful little analysis calculator and will allow you to take that to your financial planner to make sure you are in fact ready.
F financially to pivot into retirement. Okay, so you're there, you're about to retire. What do you do with the building? I got three options here. Option one, you keep the building and you use it as a passive rental income. And hey, dentists are very reliable tenants. That is a absolutely a beautiful thing to do.
The only reason to not do that is if you need to tap into the equity of your building, you're not gonna be able to do that without selling. Now, you could do possibly a line of credit to tap into the income on your building for sure. Sometimes people need that cash because maybe they wanna buy a second retirement home in.
I don't know, Hawaii or Big Bear or Mammoth or some other place. And, uh, and they want cash to do that. So they can, they can, they can sell it to have cash as a down payment on the new one and potentially if they're gonna rent out the new one. And it's a, it's a commercial asset or a better set, it's a rental asset, they could do it.
10 31, which I'm gonna talk about it here in a sec. So option one, keep the building. Use it as passive rental income from the new tenant, dentist number three, or it doesn't have to be a dentist, if you could sell it to a retail vendor and they resut the property to a different type of property. Option number two is sell a building, pay the capital gains tax, and invest the remainder.
And so if you have a $2 million building, you may sell it. You may walk away with, after all is said and done, I don't know, a million dollars, and then you can go throw that in. The stock markets, in stocks, paying good dividends. There's a lot of really good value companies out there, less sexy companies.
Been around a long time. Paying really good dividends, four, five, 6% rate dividends, and they're passive. The thing about owning your building is it's not entirely passive. I mean, the IRIS tax code calls it passive, but it's not entirely passive because you got things that go wrong. You have to renegotiate leases, you got fix things, you got tis, you got, you got complaints, you got vacancies that you have to fill.
You might have to hire a practice a, a a. Management company, they're not entirely passive. And depending on your investment personality, a lot of people just detest being pulled into that kind of thing. Oh, the ACS not working great, I gotta go fix it. I gotta call somebody, you know, I gotta have my vendor list, yada yada, my independent contractors.
And, uh, if you're into that kind of thing and you really like that. If you're not and you wanna spend your time traveling or being with kids and, and spend a hundred percent of your time doing those other things, then honestly, owning real estate is not the best type of asset for you to own. Okay? So option two is to sell a building, pay the capital tax, and invest the difference.
Option number three is you sell a building, but you exchange it. Into a new property through what's called a 10 31 exchange. If you are at all involved in real estate investing, you would know exactly what this is. This is like this, like real estate investing 1 0 1 for dummies, and the 10 31 exchange is you sell your building, you take the proceeds, and in a given time period, you use those proceeds.
A hundred percent down into a new property, then you don't have to pay taxes. Instead, you carry over what's called your tax basis from the old property into the new property. And the tax basis is simply what you bought it for, less what you depreciated it over time, plus any capital improvements. It's like a piggy bank.
And uh, and so let's say you bought a building for 2 million and over a 15 year period you'd depreciated it down to 700,000. Well, when you buy the new property, your basis in that new property, let's say, let's say you buy a $4 million property, your basis is two is $700,000. And so then you immediately in turn sold that $4 million property.
You're gonna pay taxes on $3.3 million because you carried over your tax basis. Now there's more calculations there, depending on the nuances of that particular transaction, but the key thing about a 10 31 exchanges, they're simply punting the tax bill down the road. If you didn't get what I just said, just know you're punting the tax bill down the road, and if you punt it down the road far enough.
And you pass away still owning that building. Then there's what's called a step up in basis where your beneficiaries, most likely, your kids get that building and they're, what they essentially get it for from a tax standpoint is the market value at the date of your death, and that's called a step up in basis.
And therefore it 100% escapes paying capital gains taxes on the sale. This is what extremely wealthy people do. Who are into real estate is they keep 10 31 exchanging in the bigger and bigger properties, deferring the taxes till they die, and again, they'll pull out in, they'll pull out a loan on that to live on sometimes if they want cash, and then when they die it gets stepped up and they're beneficiaries pay no taxes.
And if their total estate is less than that $12 million plus or minus here in 2026, then they don't even pay taxes on the value of that property in their estate. And if they're married, it's twice that. Now, if you're uber rich, worth 50 million, a hundred million plus, then. Yeah, you're gonna pay, uh, uh, death taxes, estate taxes on that, uh, on your estate when you pass away.
Okay? So options when you retire. Number one, keep the building passive rental income. Option two, sell a building, pay the capital gains tax and invest the remainder somewhere. And option number three, you do a 10 31 exchange to a new property. And it doesn't have have to happen right when you sell, but just sometime in your retirement, you have all three of those options.
Okay. Yep. And if you are watching my screen, like it says they're on the bottom, you could borrow against that property for non-taxable income. Alright, everyone, let's go ahead and end off with that one for this episode. On the next episode, I'm gonna end, uh, do five key takeaways with the cost segregation series here, things to remember.
And then I will, uh, also talk a little bit about. Hiring a specialist company and we will end the series there. So thanks for joining. Until next time.
Wes knows what's best for dental practices. He's been doing this for a long time and he sees lots of practices. He can tell me how our practice is doing, and what we can do to increase our productivity. With past CPA's, there were no ideas. It was all coming from me, saying "I think I can do better, but I don't know how." I come in to meet with Wes and he says "You CAN do better, and I know how."
PracticeCFO is in hundreds of dental offices around the country. They know what numbers should look like. They know what percentages of payroll, rent and supplies should be, and they will hold you accountable to those numbers, which will really help you stick to your plan and your path of growth and savings. That is invaluable
Whenever something comes up, whether it's building or practice related and we weren't sure where the numbers would go, PracticeCFO has been instrumental in helping us figure that out. I can't say enough of how important that is - that it goes beyond that initial partnership. They make sure this business marriage works.
When I go home from work, I don't spend a whole lot of time stressing about what my books look like, or how much I owe in taxes. By using PracticeCFO, the burden of keeping track of a lot of the big financial numbers and metrics are taken off my plate.
PracticeCFO helped me develop a plan for the future. I have colleagues that work with other accountants that don't have a plan - they just look at the numbers of the practice and that's it. There's no plan for 10, 20 years from now. But with PracticeCFO, you get that. PracticeCFO makes you feel like you're they're only client.
(In reference to his practice sale) What could've been super stressful, wasn't! When picking John and Wes, it was from word of mouth recommendations and other people's experiences from the past that really did it for me. And it turns out that those recommendations were right on the line.
Wes knows the business side of dentistry. His comprehensive plan will organize your personal and professional finances so you can focus on taking care of patients. Massive ROI.
I can’t say enough good things about everyone at PracticeCFO. Everyone on the team is professional, organized, knowledgeable, helpful and kind. They also respond to emails and phone calls immediately and are always happy to help. They have helped me navigate year-to-year as a business owner. PracticeCFO gives me peace of mind that my business is in good hands.
I love Practice CFO! They have helped me obtain a practice and maintain a practice. They are incredible people who are on top of everything and make owning and running the business portion of a practice easy. They couldn’t be better for my business and my sanity. They have every detail of the business and taxes taken care of where all I have to do is show up and follow their easy steps to success!
Practice CFO has the best tools I’ve seen for personal tax and financial planning in addition to top-tier corporate tax and accounting services. I have been very pleased with the level of quality service. They manage my monthly bookkeeping and accounts payable. It is a great system and saves me a ton of time, and it allows us to have monthly financial statements within a week of month end.
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