Physicians Selling a Medical Office Building: Exchange, REPS and Depreciation

The decision is the building, because your practice income is out of reach of any depreciation you buy

Section 469(c)(2) makes any rental activity passive, and section 469(c)(1) makes any trade or business in which you do not materially participate passive as well. Passive losses offset passive income. Your practice income, whether W-2 wages from a hospital or distributions from a professional corporation in which you work, is nonpassive. A depreciation deduction that arrives on a K-1 from a fund cannot reach it.

The two doors around that rule do not open for a working physician. Section 469(c)(7)(B) requires that more than half of all your personal services in trades or businesses, and more than 750 hours, be in real property trades or businesses in which you materially participate; a full clinical schedule fails the first test on its own. On a joint return the requirements "are satisfied if and only if either spouse separately satisfies such requirements," so a spouse who manages the family's rentals full time can qualify, but your hours do not pool with theirs. The real estate professional tests go into the record-keeping.

The $25,000 allowance in section 469(i) is reduced by half of adjusted gross income over $100,000 and is gone at $150,000, which is below most physicians' income. Can bonus depreciation from a fund offset W-2 income answers the question most physicians arrive with.

Rent from a building leased to your own practice is not passive income, and neither is the gain when you sell it

This is the rule physicians most often miss. Reg. section 1.469-2(f)(6) recharacterizes net rental activity income from an item of property as "not from a passive activity" if the property "is rented for use in a trade or business activity in which the taxpayer materially participates." A building your practice rents from your LLC is exactly that. The rent is nonpassive, so losses from a bonus depreciation fund cannot offset it either.

The regulation's definition of net rental activity income in paragraph (f)(9) includes income from the property's rental or disposition, so the gain on selling the building to a third party while the practice is still your tenant is swept into the same nonpassive bucket. A physician who sells the building for cash the year before retiring and buys fund interests to offset the gain will find the loss suspended, not used.

The exchange is what moves the numbers. Section 1031 defers the whole gain; nothing has to be offset. Once you have retired and the building is gone, the income you receive from passive replacements is passive, and that is where a fund's losses can land.

A sale-leaseback to an investor fixes the price while the practice stays, and the lease is what the buyer pays for

Investors in medical office buildings pay for a lease with a term, a creditworthy tenant and rent set at market. If your practice will stay in the building, sell it to an unrelated investor with a lease back to the practice entity, then exchange the proceeds. The sale-leaseback guide covers the ownership and rent tests; keep the term under the 30-year mark that Reg. section 1.1031(a)-1(c) treats as a fee.

If you will keep referring patients to a buyer of the practice who furnishes designated health services, the lease is a financial relationship under the physician self-referral rules, and selling a medical practice building sets out the office-space exception. The medical office property page covers how buyers underwrite those leases. Do not sell the building to your own professional corporation: section 1239 makes gain on depreciable property sold to an entity you own more than 50% of ordinary income.

Expensed build-outs come back as ordinary income on a cash sale and ride along in an exchange

Exam-room cabinetry, specialty equipment hookups and other items that a cost segregation study classed as personal property and you expensed are section 1245 property, and section 1245(a)(1) treats gain up to the depreciation taken as ordinary income that "shall be recognized notwithstanding any other provision of this subtitle." Section 1245(b)(4) then limits that recognition in a section 1031 exchange to the gain actually recognized plus the value of non-section 1245 property received, which in a full exchange of real property for real property keeps the recapture deferred.

The straight-line depreciation on the building itself is unrecaptured section 1250 gain, taxed at a maximum 25% rate under Topic 409 on a cash sale and deferred in an exchange. Public Law 119-21 made 100% bonus depreciation permanent for qualified property acquired after January 19, 2025, which increases both the deductions available on a new build-out and the recapture waiting at the end of it; the 2026 bonus depreciation rules cover what qualifies.

Worked model: a $3,000,000 building, a cash sale against an exchange, and where the fund enters

These numbers are hypothetical and rounded. A physician's LLC owns a debt-free medical office building worth $3,000,000 with an adjusted basis of $1,000,000: $800,000 of straight-line depreciation has been taken on the building and $400,000 of build-outs were expensed.

• Cash sale: $400,000 of section 1245 recapture at ordinary rates, $800,000 of unrecaptured section 1250 gain at up to 25%, and $800,000 of long-term gain at 15% or 20% depending on where 2026 taxable income lands against the $613,700 joint ceiling for the 15% band in Rev. Proc. 2025-32, plus net investment income tax if it applies. The gain is nonpassive under the self-rental rule, so fund losses bought that year would be suspended.
• Full exchange into all-cash DSTs: all $2,000,000 of gain deferred. The DST interests produce rental income that is passive in your hands.
• Year after retirement: with no practice income, passive income from the trusts and any other rentals is what a bonus depreciation fund's first-year loss can offset. The fund's own gain, when it sells, carries its own recapture.
• Before choosing, have your CPA re-run the three lines on your real basis and your 2026 income, because the ordering changes the result.

Replacement: an all-cash DST for the retiring physician, with the fund as a second step rather than a substitute

A debt-free building points to an all-cash traditional DST, and Rev. Rul. 2004-86 treats the beneficial interest as an interest in real property for section 1031. Medical office DSTs keep the proceeds in a sector whose leases you understand. DST interests cannot be sold on demand, the sponsor decides when the property is sold, and the real estate can lose value, so your principal is at risk.

A bonus depreciation fund is built for investors with passive income or gains to offset; the client's own page describes it that way. It is a separate purchase, not replacement property, and can I 1031 into a bonus depreciation fund explains why. If part of the building is sold for cash outside the exchange, that capital gain can go to an opportunity zone fund within 180 days, though the section 1245 portion, being ordinary income, cannot.