Healthcare Advisor: Repair Regs and Cost Segregation Present Tax and Reimbursement Planning Opportunities for Healthcare Entities Lessors and Lessees

September 6, 2016

Leasing Real Estate

Real estate is often viewed as a necessary evil by most healthcare providers with differing views of whether property is leased or owned. The problem has become more complicated as hospitals acquire practices but leaseback the physician-owned real estate. In the future, it may become even more of a challenge with the changes in provider-based status. We believe that expanding a health system under the new rules will involve considering options that include joint venture with niche operators and understanding the options for real estate ownership.

Not Just for Taxable Entities

For those of us old enough to have once understood Medicare cost-based reimbursement and the importance of using the proper useful life for new hospital buildings and renovations, we understand how important depreciation is to the critical access hospital and the feasibility of any capital project. Segregating cost into the proper components helps a facility receive its share of cost reimbursement from depreciation.

Lessor and Lessee – Interest in the Tax Deduction

Recent IRS regulations on tangible property (sometimes referred to as the “repair regs”) provide guidance on whether an expenditure should be treated as a capitalized asset for tax purposes or whether it can be deducted. As it applies to real estate, the rules present some tax planning opportunities for both landlords (lessors) and tenants (lessees).

Generally, a taxpayer must capitalize amounts paid to improve a “unit of property” owned or leased by the taxpayer. Capitalized improvements include those involving a betterment of the property, a restoration or an adaptation to a new or different use. A unit of property will likely differ for the lessor and lessee. Typically, the lessor’s unit of property would be the entire building or building system; for the lessee, the unit of property would be only the portion of the building or building system leased. An improvement made by the lessee would be a separate unit of property.

If a lessee pays for an improvement to property which it does not own and the payment constitutes a substitute for rent, it is deductible by the lessee as rent and generally treated as rental income to the lessor. If the lessor grants a construction allowance to the lessee to make improvements and certain conditions are met, the lessee excludes that allowance from income and the lessor treats the expenditure as a capitalized asset subject to cost recovery deductions (generally over 15 or 39 years).

Because the unit of property for the lessor is usually the entire building or building system, whomever pays for the improvement may produce different results. Under the new rules, a lessor’s expenditures that would normally be treated as capitalized leasehold improvements may now be deductible. For example, if the lessor’s expenditures are for improvements to one floor of a 10-story building, these expenditures may not be considered enough to improve the building or any defined building system as a betterment, restoration or adaptation. In such case, the lessor would not be required to capitalize the expenditure as an improvement. (This assumes the lessor did not previously write-off their basis in a building component as part of updating space for the new lessee). Conversely, if the lessee paid for the improvements to their space, it is likely the improvement would be a capital expenditure for them because the unit of property would be limited only to the portion of the building or building system which they leased and thus the improvement would be considered significant.

Critical Access Hospitals and Taxable Real Estate

Companies that have purchased, expanded or remodeled real estate may want to consider a cost segregation study to identify and classify costs of the project which would otherwise be considered real property to a shorter depreciable life for the purposes of state and federal income taxes. The study analyzes various components of a building to identify costs qualifying for a shorter recovery period. This reclassification results in increased cash flow through the deferral of federal and state income taxes.

Similarly, critical access hospitals enjoy cost reimbursement for depreciation based on Medicare reimbursement principles which include a discussion of useful life. It makes a lot of sense to ensure a hospital is using the most appropriate useful life for components which have shorter depreciable lives.

Who Should Consider

Good candidates for these studies are companies that have recently built, remodeled or purchased a building with a significant tax basis or in the case of a hospital a significant construction cost.

Consult your Elliott Davis Decosimo tax or healthcare advisor or reach a member of our team at elliottdavis@elliottdavis.com for guidance on your unique opportunities under the repair regulations or cost segregation under both tax and reimbursement regulations.