Updated 8/21/2023
Dr. Steve Suh
Ownership in ambulatory surgery centers (ASC) by surgeons and procedure-oriented physicians has been on the rise for many years. The most common specialties that use ASCs include ophthalmology, gastroenterology, plastic surgery, orthopedic surgery, otolaryngology, urology, podiatry, dermatology, and pain medicine. Even though physicians perform surgery at their ASC on a regular basis, they probably do not “materially participate” in the management of the facility. Therefore, the K-1 income from the ASC would be considered a passive gain. Unfortunately, this income would still be taxed at the individual’s ordinary tax rate, which could be as high as 37% (as of 2023).
One strategy to offset the ASC-related passive income involves investing in commercial real estate syndications, especially multifamily assets, and then utilizing the depreciation to reduce one’s taxes. Most sponsors of multifamily syndications will do a cost segregation study that will take certain components of the real property and accelerate the depreciation from 27.5 years to 5, 7, or 15 years depending on the personal property or improvement. The Tax Cuts and Jobs Act of 2017 enabled business owners and real estate investors to further accelerate the depreciation to 100% in year one (prior to 2023)! This bonus depreciation is set to phase out starting in 2023 (80%) and decreases by 20% each year until it goes to zero unless it is repealed or renewed.
When you invest money into a real estate syndication, you will receive a Schedule K-1 (like you do for your surgery center) that will summarize your distributions and passive activity gains or losses. The lines that show the “Ordinary business income (loss)” and “Net rental real estate income (loss)” will determine whether you have a passive gain or loss. If these lines have a negative amount, then you can utilize these on-paper losses against any passive gains that you may have – even income from your ASC! Physician shareholders of dialysis centers, infusion centers, and imaging facilities could also be getting passive income from these entities, so this strategy is not limited to owners of ASCs. Unfortunately, passive losses will not offset capital gains, dividend income, or active income from your W-2.
Since I started passively investing in real estate syndications, I have been able to reap the benefits of the bonus depreciation. For most of the multifamily deals, I have received on-paper passive losses of up to 100% of my investment in the first year! I forgot to add that you do not have to have the “real estate professional” status to take advantage of this powerful tax-saving strategy.
Here is an example of how this might work. A physician, who is a part-owner of a surgery center, earned $30,000 as her portion of the yearly distributions. That year, she also invested $100,000 passively in a multifamily syndication. The sponsor had a cost segregation study performed on the property to enable their investors to utilize bonus depreciation. In March of the next year, she received the K-1 for this investment, and it showed a net rental income loss of $80,000 – i.e. on-paper passive activity loss. Because of this, she was able to reduce her taxable income by $30,000 by using this passive loss to offset the passive gain from the ASC income. At the 35% tax bracket, this would equate to putting $10,500 back into her pocket. If she were not able to utilize the remaining $50,000 of passive losses in that year, she could carryover these losses on next year’s tax return to offset her future ASC income. By that time, she should also be getting some real estate rental income (passive gain) from the apartment, and, of course, she probably will not pay taxes on this either because she can apply some of the unused, passive losses.
Forward-thinking investors will inquire about depreciation recapture when the apartment is sold. What the IRS giveth, the IRS can take away. The capital gain at the sale would come partly from the decreased cost basis from the depreciation and from the appreciation of the property. In this scenario, each portion of the gain is taxed differently. The gain from the depreciation is taxed at your ordinary income tax rate (capped at 25%), and the appreciation part is considered long-term capital gain (tax capped at 20%) assuming the asset was held for longer than a year. Because this investment was passive for the investor, the IRS will make an exception to allow this type of capital gain to be considered passive as well. By investing in another multifamily syndication that same tax year or freeing up the unused passive losses from previous years, you could offset these gains from the sale with the stored-up depreciation! As they say, it always pays to plan ahead.
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Disclaimer: Tax laws are always subject to change. This article was written in August of 2023 so tax laws may have changed by the time you read this. I am not an accountant, attorney, or financial advisor. You should always seek experts in these areas when investing in any asset class. Nothing in this article should be considered financial advice. Investing involves risks which you assume. It is your duty to do your own due diligence. Read all documents and agreements before signing or investing in anything. It is your duty to consult with your own legal, financial and tax advisors regarding any investment.
Steven Suh, MD is an ophthalmologist and co-creator of Merge Medical. He is also one of the founders of Left Field Investors, an educational site and networking community of like-minded individuals interested in creating financial freedom through passively investing in real assets that generate real cash flow. After owning a few small residential rentals and seeing that it was not easily scalable, he transitioned to the world of passive investing in commercial real estate syndications. He enjoys learning and talking about real estate and hopes to educate more people about the merits of passive investing. You can contact him at [email protected].
