Deductibility of retirement community fees.

The Tax Court's decision in Delbert L. Baker, 122 TC 143 (2004), provides additional taxpayer flexibility in determining the portion of continuing care retirement community fees deductible as Sec. 213 medical expenses.

Facts

Delbert Baker and his wife were residents at Air Force Village West, Inc. (AFVW), a California retirement community. The Bakers executed an agreement entitling them to lifetime residency at the facility. AFVW provided four levels of living accommodations and service: (1) independent living; (2) assisted living; (3) special care; and (4) skilled nursing care.

Mr. Baker was a member of an ad hoc committee of AFVW residents using certified financial data provided by the community's vice president of finance to determine the medical deduction portion of the residents' monthly fees. The committee concluded that approximately 40% of the fees were attributable to medical care.

IRS's Stance

Oil audit, the IRS disallowed a portion of the Bakers' medical deduction. Using a percentage allocation method (which was consistent with its prior rulings), the Service permitted only 19.01% of the monthly fees as a medical deduction. Also, it completely disallowed additional deductions for the taxpayers' use of AFVW's pool, spa and exercise facility.

Tax Court's Decision

At trial, the Service switched gears aim claimed that the allowable medical deduction had to be based on actuarial calculations, taking into consideration healthcare utilization and longevity. The Tax Court disagreed, concluding that the Bakers had produced enough credible evidence to shift the burden of proof to the Service under Sec. 7491. The court cited the IRS's 35-year history of allowing the use of the percentage method. According to the Tax Court, the actuarial method is "so complex as to defy full explanation."

Use of percentage method: While the Tax Court approved use of the percentage method, it modified the approach used by both parties. Instead of allowing a percentage of the fees paid by each resident, the court concluded that the allocation percentage had to be based on the number of community residents and the weighted average monthly service fees. According to the court, in using the taxpayers' approach, occupants of larger or double occupancy living units would receive a higher medical expense deduction based solely on the higher fees necessitated by the larger units, without regard to occupancy.

In addition, the court denied the taxpayers' medical expense deduction for use of APVW's pool, spa and exercise facility, because they failed to produce a supportable allocation of the monthly fees attributable to them. The court noted that the facilities were available to all residents and their families for recreational use, and the taxpayers failed to establish their portion of use for medical purposes. The court also noted that no deduction is available for such amenities if their use is merely beneficial to the taxpayer's health.

Conclusion

The Baker decision reaffirms that taxpayers entering retirement communities may continue to deduct the medical portion of their entrance and monthly care fees; no costly actuarial analysis is needed. Taxpayers now have a choice of either the pre-approved IRS percentage method or the Tax Court's modified percentage method, whichever produces the greatest tax benefit. Until further notice, either method may be used with confidence, because both have substantial authority for penalty avoidance purposes; see Regs. Sec. 1.6662-4(d).

FROM THOMAS PFLANZ, CPA, CFP, McGOWEN, HURST, CLARK & SMITH, P.C., WEST DES MOINES, IA