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Tax Court determines allocation of retirement residence fees to resident's medical expensesMarch 2004
Delbert L. Baker, (2004) 122 TC No. 8The Tax Court has approved the use of the percentage method for determining what portion of monthly fees paid by a taxpayer to a continuing care retirement community qualified as deductible medical expenses. In doing so, the Tax Court rejected IRS's contention that the deductible amount had to be determined based on an actuarial analysis taking into account life expectancy and health care level expectancy. But no deduction was allowed for costs related to use of the pool and spa at the facility. Background. IRS's long-standing position is that a portion of the fees paid by a resident to a nursing facility or retirement community that provides medical services can be deducted as a medical expense. The proper allocation of medical to total fees could be determined by dividing all directly-related medical expenses by total expenses, i.e., the percentage of the total expenses of the facility that represents medical expenses. (Rev Rul 75-302, 1975-2 CB 86 ; Rev Rul 76-481, 1976-2 CB 82) There is no requirement in the rulings that taxpayers engage in an actuarial analysis to factor in life expectancy and health care level expectancy of the resident population of a continuing care retirement community to determine estimated lifetime medical care costs and total costs. Facts. Village West (VW) is a gated, guarded, perimeter fenced, resortlike retirement community in California that is owned by a nonprofit organization. Its residents are retired and honorably separated officers of the armed forces and their spouses. VW provides for different levels of living accommodations: independent living unit (ILU); assisted living; special care (Alzheimer's/Dementia unit); and skilled nursing. In '89, Delbert Baker and his wife chose a two bedroom, two bath, duplex unit for their ILU accommodations. In exchange for an entrance fee of $130,000 and ongoing monthly service fees, they were entitled to lifetime residence at VW. On their joint tax return for '89, the Bakers deducted $35,000 of the entrance fee as a medical expense. Observation: The record does not indicate how the amount of the deduction claimed by the Bakers was determined. Nor does the opinion indicate whether IRS audited that return or otherwise questioned the deduction. For the years at issue, the resident council of VW, using the percentage method, calculated that the percentage of monthly service fees allocable to medical care were 40.3% (for '97) and 41.6% (for '98). Based on these calculations, the Bakers claimed that $16,448 of their monthly service fees for the two years were allocable to medical care. The Bakers also claimed $7,057 for use of the pool, spa, and exercise facilities at VW. This was based on a letter from their doctor saying that it was “imperative” for Mr. Baker to exercise at least three times a week to treat his hypertension, valvular heart disease, hyperlipidemia, and degenerative arthritis. IRS position. Based on the report of an actuary who used the actuarial method, IRS said that the Bakers could claim only about $10,000 of the service fees as medical expenses. The actuarial method used projections of longevity and health care utilization to estimate the deductible portion of fees paid by a taxpayer to a retirement community. In addition, IRS completely disallowed any deduction for use of the pool, spa, and exercise facilities. Observation: The Tax Court opinion says that IRS's “current position is that the actuarial method is the correct way to calculate the deductible portion” of monthly service fees. However, the IRS rulings at least imply that the percentage method is an appropriate method to use, and those rulings have not been revoked or modified. Tax Court view. The Tax Court, agreeing with the Bakers, said that the percentage method is an acceptable method of allocating service fees to medical care. Properly applied, the percentage method provides a reasonable and straightforward approach for determining the allocation. It provides a direct link between the actual fees paid by residents and the medical costs incurred by the facility during the year. The actuarial method is more complex; according to the Tax Court “so complex as to defy full explanation.” Even if the actuarial method is more precise, the Tax Court felt that IRS, having approved use of the percentage method for many years, could not now compel the Bakers to use the actuarial method. The Bakers argued that the allocation should be based on the actual fees they paid. The Tax Court found fault with this approach, finding no relationship between the health care expenses of residents and the size and cost of their ILUs. For example, under the Bakers' approach, a single occupant of an ILU would get the same medical deduction as two or more persons sharing a similar ILU. Similarly, residents of ILUs that are larger than the average (and thus pay larger monthly service fees) would get a correspondingly larger medical deduction. The court concluded that the allocation percentage must be applied based on the number of residents and the average weighted service fees. Illustration : The medical expenses of a retirement facility divided by total costs yields an allocation percentage of 32%. The facility had 600 residents and they paid total annual service fees of $8 million, or a weighted annual average service fee of $13,333. Applying the allocation percentage of 32% results in a medical care allocation of $4,267 per resident. No deduction for exercise facilities. The Tax Court rejected the additional medical deduction claimed by the Bakers for a portion of the monthly service fees allocable to the pool, spa, and exercise facilities. An important consideration that must be satisfied to qualify for the deduction is whether the expenditure would have been made if there had been no illness. The facilities here were available for recreational use by the Bakers and their family and the Bakers failed to establish what portion of Mr. Baker's use was for medical purposes.
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