How To Handle Practice Real Estate Matters
By: Blake W. Hassan, CPA, JD*
Doctors in group practice often own one or more of the buildings in which they practice. When doctors buy in to practice ownership, Hassan is often asked if they should be allowed to buy in to practice real estate ownership as well.
Problems with Disparate Ownership
Disparate ownership between the practice and related real estate often leads to divisive problems in a group practice, says Hassan. The parties often disagree on matters such as a fair rent to charge, when routine maintenance (painting, re-carpeting, etc.) should take place, and if and to what extent expansion and renovation should be undertaken. In some cases, the divisiveness is so toxic that it leads one or more partners to leave the practice, creating disastrous financial consequences for all involved.
That’s why Hassan recommends bringing all partners into co-ownership of each building in which they practice. Doctors need to understand that the continuing success of the practice is more important than the value of the building, and that building co-ownership is often critical to maintaining the practice’s success.
Yet, the economic reality is that few doctors buying in can afford payments for the practice and the real estate at the same time. What to do? Hassan solves this dilemma by granting the new practice partner an option to purchase an equal ownership in the real estate, exercisable only after completing the practice buy-in payments.
In the interim, where disparity in ownership exists, he recommends that the practice retain a commercial real estate broker, specializing in medical/dental office space, to establish a fair market rent and other equitable lease terms. This can minimize the divisive issues until practice and real estate ownership can be equalized.
How to Equalize Ownership
The real estate buy-in price may be substantial if the office building’s value at the date the option is exercised (determined by an independent third party appraisal) is significantly greater than the related mortgage debt on the property. This in turn can require sizable payments to buy in to equal ownership. In order to facilitate the process, Hassan recommends that the building be refinanced at 80-85% of its current fair market value.
Refinancing the property to strip out most of the equity helps all parties involved, says Hassan. Once the existing mortgage and closing costs are paid off, the selling doctors can receive the remaining mortgage proceeds tax-free. And the new partner’s out-of-pocket buy-in price decreases due to the reduced equity in the building, although they must agree to become liable on the new mortgage.
The selling doctors may agree to take all or a portion of the real estate buy-in price in installment payments (normally over 10-15 years) to further ease the financial pressure on the new doctor buying in. This works well, as long as a reasonable interest rate is charged, says Hassan. The selling doctors may not need the immediate cash as much as the buying doctor needs the convenience of payments being stretched out over time.
Titling the Property
If the buildings are now owned in one or more doctor’s individual names, joint names, or an unincorporated general partnership, Hassan recommends that the title be transferred into a limited liability company (LLC), in order to limit each real estate partners’ liability, and to provide ease for future transfers. This allows the group to add or subtract LLC partners/members without further need to retitle the property, which gives rise to real estate transfer taxes in most states.
Ask your real estate attorney if any transfer taxes will be due if you simply transfer the title into an LLC and retain the same ownership interests. Most states provide a transfer tax exemption when ownership of the real estate transferred into the LLC is the same as the ownership of the LLC interest received in the exchange. Once this transfer has been accomplished, future transfers of LLC interests to new partners buying in can be achieved without incurring any additional transfer taxes, in most states.
Real Estate Buy-Out Provisions
Doctors titling the practice real estate inside an LLC need to establish an operating agreement outlining how the LLC will be managed, including when and how distributions will be made to the partners/members. This LLC operating agreement normally includes buy/sell provisions as well.
Unlike practice buy/sell provisions, Hassan does not recommend a mandatory obligation to purchase the partner’s interest in the real estate LLC, except in the event of death. In all other cases where the partner has left the practice, the remaining partners are granted an option to purchase the selling member’s interest.
* McGill and Hassan, P.A. specializes in providing legal services to dental professionals. For more information, call 704.424.5450.
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