When do capital expenditures qualify as deductible medical expenses?

With steadily rising standard deductions, as well as increases in personal incomes that limit the possibility of exceeding the 7.5%-of-adjusted-gross-income (AGI) floor, the use of the medical expense deduction has declined in recent years. Nonetheless, it may provide relief to taxpayers with unusual medical circumstances. Taxpayers who suffer from catastrophic illnesses or accidents clearly have little trouble meeting the requirements for the general deduction. However, occasionally a situation arises that does not conform to the usual concept of a deductible medical expense. Sec. 213 reads:

(a) Allowance of deduction. There shall be allowed as a deduction the expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer, his spouse, or a dependent (as defined in section 152), to the extent that such expenses exceed 7.5 percent of adjusted gross income.

(d) Definitions.

(1) The term "medical care" means amounts paid--

(A) for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body,

The key term is mitigation (i.e., to lessen or alleviate). There can be no argument that for some medical conditions, all that can be done is to relieve pain or suffering. Typically, when a medical problem calls for a capital expenditure, the goal is mitigation. For instance, a patient with a respiratory or cardiac problem may be unable to climb stairs or may have impaired muscle function. These patients and their physicians are not hoping to cure the problem with an elevator or a swimming pool, but rather to alleviate symptoms or perhaps just to prevent further damage.

Capital Expenditures Qualifying as Medical Expenses

Regs. Sec. 1.213-1 (e)(1)(iii) addresses medical expenses that qualify as capital expenditures. Principally, the IRS will not disallow amounts paid that otherwise qualify as medical expenses simply because they are capital in nature. However, if a taxpayer claims a medical capital expenditure, he must meet the following criteria:

* The expenditure must have as its primary purpose the medical care of the taxpayer, his spouse or his dependents and

* It must be related only to the sick person, not to the permanent improvement of property; or

* If the expenditure is for the betterment of property, only the portion that exceeds the increase in the property's value may be claimed.

Moreover, the cost of operating and maintaining the capital asset is deductible. According to Regs. Sec. 1.213-1, if the initial capital expenditure qualified as a medical expense, the full cost of its operation and maintenance qualifies, regardless of how much of the original cost qualified. Put simply, if the capital expenditure itself qualified as a medical expense (yet was not deductible because, for example, its cost was less than the increase in value of the underlying property), the asset's operating and maintenance costs are still deductible.

Neither Sec. 213 nor Regs. Sec. 1.213-1 specifically states that a physician's advice is required to substantiate the medical necessity of any expenditure. However, in many cases dealing with disputed capital medical expenditures, the reason for denial was failure to show medical purpose. Therefore, a taxpayer must produce solid documentation to substantiate the deduction, including a physician's "statement of need" for the expenditure.

Although the Service no longer issues advance rulings or determination letters in this area, it released Rev. Rul. 87-106 on the deductibility of capital expenditures for medical purposes. The ruling clarified that a capital expenditure related only to a sick person's medical care (and not to the permanent improvement of property) was deductible as a medical expense. In addition, a capital expenditure that was for the permanent improvement of property was deductible to the extent its cost exceeded the increase in the property's value. Further, the ruling included 13 expenditures that did not increase a property's value:

* Constructing entrance or exit ramps to a residence;

* Widening doorways at entrances or exits to a residence;

* Widening or otherwise modifying hallways and interior doorways;

* Installing railing, support bars or other modifications to bathrooms;

* Lowering of (or making other modifications to) kitchen cabinets and equipment;

* Altering the location of (or otherwise modifying) electrical outlets and fixtures;

* Installing a porch lift and other forms of lifts (generally, this does not include elevators, as they may add to a residence's fair market value and any deduction would have to be decreased to that extent);

* Modifying fire alarms, smoke detectors and other warning systems;

* Modifying stairs;

* Adding handrails or grab bars, whether or not in bathrooms;

* Modifying hardware on doors;

* Modifying areas in front of entrance and exit doorways; and

* Grading of ground to provide access to a residence.

These alterations and modifications, according to the ruling, are generally fully deductible when their purpose is the medical care of a taxpayer, his spouse or dependents. In addition, Rev. Rul. 87-106 specifically stated that the list was "not exhaustive" and "substantially similar expenditures" may also be eligible for medical expense treatment.

Ordinary Medical vs. Capital Expenditures

Example 1: Taxpayer A is single with no dependents, and has incurred hospital and physicians' bills totaling $7,000 due to injuries sustained in an accident. A has $33,000 of AGI and no other itemized deductions. Taxpayer B is single with no dependents and has also incurred hospital and physicians' bills totaling $7,000 due to injuries sustained in an accident. In addition, B's doctor has informed him that his hip injury is permanent, prohibiting him from climbing stairs. The doctor recommends that B install a stair lift in his home. B has AGI of $33,000 and no other itemized deductions.

In Example 1, B claimed the entire cost of the lift as a medical deduction. This is appropriate, given that lifts are included in the list of items in Rev. Rul. 87-106 that are generally considered not to increase the value of the underlying property. What if, instead, B was confined to a wheelchair and needed to install an elevator in his home? Assume an elevator would cost $7,500, yet would result in a $5,000 increase in the home's value. In that event, B's medical deduction for the elevator would be only $2,500; see Exhibit 1.

Litigation Issues

While no taxpayer or tax practitioner wants to contend with the IRS, sometimes it just cannot be avoided. With that in mind, it may be helpful to have an understanding of the type of matters that can precipitate a challenge by the Service and how a taxpayer can prepare to respond.

The number of cases involving medical capital expenditures actually litigated has dropped dramatically; in fact, they are currently quite rare. Of the 29 cases tried over the last 42 years, 24 involved tax years prior to 1980. Since the last significant change to the medical expense deduction in 1986 (increasing the AGI floor from five percent to 7 1/2%), the courts have heard only five cases. Of those, four were denied as not being primarily for medical purposes.

In Culmo, TC Memo 1991-441, the taxpayer had an unspecified kidney problem and consequently converted his carport into an office to continue his business activities. The Tax Court summarily denied the petition as the home office clearly had no direct bearing on the taxpayer's medical care, but rather simply allowed him to continue working.

In Keating, TC Memo 1995-101, the taxpayer attempted to claim a medical deduction only after the IRS denied her computer purchase as a business deduction. At that point, she argued that the computer was used for rehabilitative exercises following brain surgery. However, her extensive use of the machine in her husband's business and in her own doctoral studies led the court to find that the computer had not in fact been purchased for a primarily medical purpose.

Huff, TC Memo 1995-200, and Mitic, TC Memo 2000-144, plainly illustrate that although a physician's advice is essential, it is not always enough. Huff involved a doctor-recommended "health maintenance hot tub," in response to problems with obesity, intermittent depression and stress-related fatigue. The Tax Court recognized that the hot tub might have contributed to the taxpayer's general well-being, but could not agree that it was directly related to her medical care. Further, Regs. Sec. 1.213-1(e)(1)(ii) specifically excludes expenses "merely beneficial to ... general health."

Mitic also had a physician's written recommendation, in this case for the removal of a bedroom carpet. Unfortunately, the taxpayer removed the carpet and installed hardwood flooring throughout the entire house, and waited 13 years from the date of the doctor's letter to address the problem. In addition, the taxpayers were in the midst of remodeling and refurnishing their home to use it as a showcase in their new business when they finally decided to follow the physician's advice.

Zipkin, DC MN, 10/18/2000, is the only recent case resulting in a favorable decision for a taxpayer. It involved some unusual circumstances in which the taxpayer made prepayments over several years for the construction of a specially designed house. The taxpayer did not claim the prepayments until he completed the house, as it provided no medical benefit until that time. The Service denied the deduction on the grounds that prepayments for medical care are not deductible when paid; because the taxpayer was legally obligated to make the payments in the earlier years, the amounts were also not deductible in the year the house was completed. The district court ruled for the taxpayer, stating, "based on the unique facts of this case, the deduction ... is properly taken in the year the home became habitable."

Example 2: Taxpayer C was the picture of health and participated in triathlons and other athletic events before he contracted polio. As a result of that illness, both of his arms withered and he lost 60% of their use. To regain his strength, his doctor prescribed swimming; however, there were no pools in the neighborhood and the nearest pool was 10 miles away.

For $95,000, C built his own pool, covered and heated so that he could swim throughout the year. An appraiser said that the pool increased C's property value by $50,000. C believes he has a $95,000 deduction for the current year's tax return.

Can C deduct the cost of the swimming pool? The answer is: partially. However, given the $50,000 increase in value of his property, only $45,000 of the cost is deductible as a medical expense. Both the doctor's formal prescription for swimming and the lack of availability of a pool in the vicinity serve as support for C's need to build his own pool. In addition, C should be prepared to show that he does, in fact, use the pool year-round (i.e., it is heated and covered) and that its use for entertainment or recreational purposes is strictly incidental. With these facts in place, if the $45,000 exceeds 7.5% of C's AGI and he itemizes his deductions, he does have a qualified medical expense.

The only remaining potential obstacle C faces is whether the IRS will challenge the reasonableness of the expenditure. That is, can part of the cost be attributed to architectural or aesthetic purposes, and could an adequate pool and enclosure have been built for less? This issue is unresolved; however, the Service successfully argued in Ferris, TC Memo 1977-186, that $70,000 was a reasonable amount for the construction of a pool and enclosure. Because the tax year in question was 1971 and $70,000 was considered reasonable at that time, with inflation C probably has a good chance to prevail with a $95,000 expenditure today.

Exhibit 1: Deduction vs. Expense

Taxpayer A: ordinary medical expenses

AGI                    $33,000

Itemized deductions:
Medical                 $7,000
Less: 7.5% of AGI      ($2,475)

Deductible amount      $ 4,525
Taxable Income         $28,475

Taxpayer B: capital expenditures

AGI                    $33,000

Itemized deductions:
Medical                 $7,000
Stair lift              $3,500
Less: 7.5% of AGI      ($2,475)

Deductible amount      $ 8,025
Taxable Income         $24,975

FROM CLYDE POSEY AND TRACY L. BUNDY, SCHOOL OF PROFESSIONAL ACCOUNTANCY, LOUISIANA TECH UNIVERSITY, RUSTON, LA (NEITHER AFFILIATED WITH GRANT THORNTON LLP)