If you're like most high-earning ophthalmologists, you're intently seeking ways to trim your income tax bill at year's end. Ophthalmologists typically have substantial incomes that are heavily taxed. Paying a disproportionate amount of income taxes is a great barrier to achieving financial independence.

ACTIVE VS. PASSIVE INCOME

Because your greatest source of income is probably your ophthalmic practice, and possibly the real estate that you lease to your practice, you may be considering using the real estate you lease to the practice as a way to convert active income into passive income.  (The IRS Code characterizes income as passive or nonpassive -- i.e., active.)

A passive activity is a trade or business in which the taxpayer doesn't materially participate. A rental activity is also almost always classified as passive, even if the taxpayer actively participates in the management duties.

Generating passive income is less taxing because it isn't subject to the Federal Insurance Contributions Act (FICA) and Medicare taxes, and can also offset passive losses. Therefore, in some cases it makes financial sense to convert active income into passive income because you pay less in taxes.

Before making this choice, however, you must investigate it carefully. Although this apparent loophole may seem appealing, you need to know more to avoid a tax trap for the unwary.

THE SELF-RENTED PROPERTY RULE

If you rent your personally owned building to your medical practice, the IRS probably has your number -- Treasury Regulation 1.469-2(f)(6), to be precise. According to this IRS rule, passive income doesn't include the net rental income from a property if it's rented for use in your own trade or business.

Your tax oasis has become a mirage!

The rule is two-pronged. It recharacterizes the net rental income from the property (what's left after taking gross income and subtracting deductions) as active. (This doesn't apply to a loss, however.) Also, the rule applies only if the property is rented to a trade or business activity in which the taxpayer materially participates.

The rule was designed to prevent a taxpayer from enjoying the best of both worlds from the same transaction -- personally generating passive income that could be offset by passive losses from other sources, while the ophthalmology practice deducts the rent payments as a nonpassive expense.

When the rule was first promulgated, creative tax advisers marketed this loophole to physicians because the language of the ruling didn't directly refer to regular C corporations (i.e., an ophthalmologist's personal service corporation). But when the rule was later tested in court cases, it was adjudged to include the C corporations. Thus, the self-rental opportunity was effectively eliminated.

DISCIPLINED PLANNING

Sound financial planning involves knowing when to be leery of some tax planning strategies as well as when to implement them. We advise clients not to give up on some oases just because they've encountered a few mirages along the way. Following a disciplined pattern of tax planning as part of your long-range financial plan is the surest way to achieve financial independence.

Richard J. Alphonso, JD, CPA/PFS, M.S.T., and Anita S. Frank, CPA, are president and tax manager, respectively, of The Financial Advisory Group, Inc., in Houston. The Financial Advisory Group provides personalized fee-only financial planning, investment management and business consulting services.