Dentists Selling the Practice Building: Lease It, Sell It or Exchange It

The practice buyer and the building buyer are usually two different parties, so decide the building on its own terms

Dental support organizations and most individual buyers purchase the practice assets and sign a lease. Equipment, patient records and goodwill are allocated under section 1060, which makes a written allocation "binding on both the transferee and transferor unless the Secretary determines that such allocation (or fair market value) is not appropriate," and none of those assets is real property under Reg. section 1.1031(a)-3. The dental office property page covers which fixtures count as real estate; this page is about what you do with the building once the practice is sold.

Three paths are open. Keep the building and lease it to the practice buyer, with or without a purchase option. Sell it now to an investor who wants a dental building with a signed lease. Or sell it to the tenant later when the option is exercised. Each path can end in an exchange, because a building leased to a tenant is held for investment and the building your own practice occupied was held for productive use in a trade or business, both of which section 1031(a)(1) covers.

What you cannot do is exchange the practice. Nor should you sell the building to an entity you control: section 1239 makes gain on depreciable property sold to a corporation or partnership more than 50% owned by you ordinary income, and section 1031(f) adds a two-year rule to any exchange with a related party.

A lease with a purchase option keeps the rent now and the exchange later, if the option and the term are written with the exchange in mind

Under Reg. section 1.1031(a)-3(a)(5), "an option to acquire real property" is a real property interest, so granting the tenant a right to buy does not take the building out of section 1031. The exchange happens when the option is exercised and the building transfers; Reg. section 1.1031(k)-1(b)(2) starts the 45-day identification period and the 180-day exchange period on "the date the taxpayer transfers the relinquished property," which is the option closing, not the day the lease was signed.

Keep the lease short of thirty years including renewals. Reg. section 1.1031(a)-1(c) treats a leasehold with 30 years or more to run as like-kind to a fee, which is a problem for the tenant's tax position and a flag on yours. A ten-year initial term with two five-year renewals stays well inside the line, and the sale-leaseback guide covers the rent and ownership tests a buyer will apply.

Set the option price with the exchange in mind. A fixed price agreed today locks in the sale value that will determine how much you must reinvest; a price tied to an appraisal at exercise tracks the market. Either way, sign the exchange agreement with a qualified intermediary before the option closing, because cash that reaches your account first is boot.

Selling the building now, with the buyer's lease attached, moves the exchange clock to the date you choose

Investors in net-leased medical and dental buildings pay for a signed lease and a tenant with credit, so the lease negotiated at the practice closing is also the asset you are selling. A sale to an investor at the same time as the practice sale, or a few months after, puts the building's price with the intermediary and leaves the practice price with your professional corporation.

Timing is the advantage. The practice closing can slip through credentialing and the buyer's diligence; a building sale with a lease back to the practice closes on its own date and starts its own clock. Selling a medical practice building walks through the two-closing calendar for physicians and dentists alike, and the owner-occupied building guide covers the allocation when one buyer takes both.

Worked model: a $2,000,000 building, three paths and what each defers

These figures are hypothetical and rounded. A dentist's LLC owns a debt-free building worth $2,000,000 with an adjusted basis of $700,000, after $400,000 of depreciation. She sells the practice to a support organization that signs a ten-year lease at $150,000 a year.

• Path A, sell now to an investor: the $1,300,000 gain, including the $400,000 that would otherwise be taxed as unrecaptured section 1250 gain at up to 25% under Topic 409, is deferred in full if the whole $2,000,000 is reinvested within 180 days.
• Path B, lease with an option at $2,200,000 exercisable in year five: $750,000 of rent over five years taxed as it comes, then a $1,500,000 gain deferred when the option closes, with the exchange clock starting that day.
• Path C, exchange now into a $2,000,000 house in the town where she plans to retire, rented for two years and then occupied: the gain is deferred, but no home-sale exclusion applies to a sale within five years of acquisition, and the exclusion is reduced for the rental years after 2008 when it does.
• Compare the after-tax rent in Path B with the DST income in Path A, and ask your CPA to test both against your actual basis before the letter of intent is signed.

The rent-it-then-live-in-it play works, but two rules trim what it saves

A replacement house can be a future home. Rev. Proc. 2008-16 gives a safe harbor when the dwelling is owned for at least 24 months after the exchange and, in each of those two 12-month periods, is rented at a fair rental for 14 days or more with personal use capped at the greater of 14 days or 10% of rental days. Meet it and the IRS will not challenge the house as replacement property.

Then the home rules take over. Section 121(d)(10) denies the exclusion on property acquired in a section 1031 exchange if it is sold within five years of acquisition. Section 121(b)(5) treats time after 2008 when the house was not your residence as nonqualified use and removes a proportionate share of the gain from the exclusion, and section 121(d)(6) keeps depreciation out of it altogether. The 1031 versus section 121 guide runs the arithmetic.

For a dentist who is finished with ownership, the replacement is usually an all-cash DST

Most dentists selling to a support organization are leaving management, not changing it. A traditional DST holds the building's proceeds in professionally managed property, and Rev. Rul. 2004-86 treats the beneficial interest as an interest in the trust's real estate for section 1031. A debt-free building like the one in the model points to an all-cash trust, because there is no loan to replace. Medical office DSTs keep the proceeds in the asset class you know, and spreading across more than one trust reduces the weight of any single tenant. The interests cannot be sold on demand, the sponsor controls the sale date, and the property can fall in value, so principal is at risk.

A dentist who wants to keep the decision to sell in her own hands can hold title through a direct title security instead, with management in place and the exit still hers.