34.10 Tax Effects of Moving to a Continuing Care Facility
Senior citizens who move into “continuing care” or “life-care” facilities pay large upfront entrance fees upon admittance, as well as monthly fees thereafter in return for a residence, meals, and lifetime health care, including long-term skilled nursing care, should that become necessary. The payments raise several tax issues discussed in this and the following section (34.11).
Law Alert
Portion of monthly fees deductible as medical expense.
Part of the monthly fees to a life-care community are allocable to health care, which you may deduct as an itemized medical expense subject to the 7.5% floor (17.1). Continuing care facilities generally send a statement to the residents specifying the portion of their monthly service fees that went towards health care.
The IRS and Tax Court have approved the use of a “percentage method” for allocating the community’s medical expenses among the residents. In general, the annual medical expenses of the community are divided by total operating expenses to get the medical care allocation percentage. In a particular case, the IRS could contest how the allocation is figured or how the allocated amount is divided among the residents.
For example, in a 2004 case (Baker, 122 TC 143), the IRS contested a couple’s medical expense deduction for a portion of the monthly service fees paid for their two-bedroom duplex apartment, categorized as an “independent living unit” (ILU). Using a percentage method computation supplied by the resident council of their continuing care retirement community, the Bakers deducted $6,557 of their 1997 monthly service fees and $9,891 of their 1998 monthly fees as medical expenses. The IRS initially allowed a deduction for $4,488 of the 1997 fees and $5,142 of the 1998 fees using a different percentage method. Then, when the Bakers appealed to the Tax Court, the IRS argued that the deductible part of the service fees should be figured using an “actuarial method,” which would increase the Bakers’ two-year deduction by a few hundred dollars over what the examining agent had allowed.
However, the Tax Court refused to require use of the actuarial method, which requires projections of longevity and lifetime utilization of health-care services, and is so complicated that the IRS could not fully explain the method to the Court. The Court held that the percentage method is appropriate, noting that the IRS has approved use of the percentage method in rulings since 1967. However, in applying the percentage method to determine the Bakers’ deductions, the Court had to resolve disputes over how certain expenses should be treated and how the allocated medical care percentage, once determined, should be split among the residents. For example, the Court held that the community’s interest expenses, depreciation and amortization allowances should be included in both the numerator and denominator when dividing medical costs by operating costs to determine the medical care allocation percentage.
The Court calculated that 27.93% of the community’s 1997 total costs and 30.07% of the 1998 costs were allocable to medical care. The Court then held that the Bakers could not simply multiply these percentages by the fees they paid to get their deductions. The same medical expense amount must be allocated to each ILU resident by multiplying the allocation percentage by a weighted average of the service fees paid each year by the ILU residents. The weighted average annual service fee for 1997 paid by the ILU residents was $13,902, which when multiplied by the allocation percentage of 27.93%, gave a medical care allocation of $3,883 per resident. For 1998, the weighted average annual service fee for ILU residents was $14,093, which when multiplied by the allocation percentage of 30.07%, gave a medical care allocation of $4,238 per resident. On their joint returns, the Bakers could treat double the per resident amounts as medical expenses; that is, $7,766 for 1997 and $8,476 for 1998.
Caution
Portion of nonrefundable entrance fee deductible as medical expense.
What about the upfront payments required by life-care communities? If an entrance fee or founder’s fee for lifetime care is nonrefundable, part may be treated as a medical expense (17.1) if you can prove what part of the lump sum is allocable to future medical coverage. The IRS recognizes that a deduction may be based on a showing that the life-care facility historically allocates a specified percentage of the fee to future medical care. With such proof there is a current obligation to pay and the allocable amount is treated as a deductible medical expense when the lump sum is paid. The same rules apply if the life-care or founder’s fee is paid monthly rather than as a lump sum.
Separate sponsorship gift.
In one case, an individual was allowed by the Tax Court and an appeals court to claim a charitable contribution deduction for a “sponsorship gift” paid to a life-care retirement facility where she and her husband were residents. The sponsorship gift was entirely separate from her entrance fee; it was not required for admission and did not entitle her to reduced monthly payments. She did not receive any extra benefit from her gift and was not entitled to a refund of any part of it.