How to Maximize Retirement Community Write Offs

Two surprises await many new residents of the popular continuing care retirement communities. These surprises are two tax issues that are different from those the residents are used to.

Most of these comprehensive retirement communities provide a combination of residential services and medical care. The communities usually include at least independent living, assisted living, and a nursing home.

Entrance fees. A number of retirement communities charge an entrance fee. The forms of the fee vary (see our March 2005 issue or the Housing Watch section of the web site Archive). In many cases, the fee is fully or partially refundable when the resident leaves the community.

These fees create a tax issue. If the entrance fee might be refunded to the resident or to the heirs, the IRS might decide all or part of the fee is a loan to the community. If the refund right does not have a return at least equal to a minimum interest rate set by the IRS each month, the IRS might treat it as a no-interest or low-interest loan with tax consequences.

A no- or low-interest loan will have interest imputed. You will be treated as receiving imputed interest from the community and will have to include that interest in gross income. In that case, you will be taxed on phantom income for which you never receive cash.

The rules on imputed interest are complicated. Most retirement communities try to structure their entrance fees so that they are not loans, and so far the IRS has not pushed a case on this issue. Residents have to depend on the communities to structure the refundable fees to avoid loan status, but without an advance ruling from the IRS there is no guarantee the fee won’t be treated as a loan. There is legislation in Congress that if passed would ensure that most refundable entrance fees to retirement communities are not treated as loans.

It appears the IRS does not want to spend resources on this issue, at least for now. Nevertheless, potential residents of retirement communities with refundable entrance fees should ask the communities how they believe the fees will be treated, if they will be reporting imputed interest on the fees, and if they have a ruling from the IRS. If you have a tax advisor, consult with him or her about the fees.

A related issue for the entrance fees is that a portion of them might be deductible as medical expenses. Only nonrefundable fees might be deductible.  The community must compute the portion of the entrance fee that pays for medical care and is deductible. Before entering a community, ask about the method the community uses and the percentage of the entrance fee, if any, that will qualify as a medical expense.

Monthly fees. The second issue is the deductibility of monthly fees. At most retirement communities, part of the monthly fees pays for health care; the rest pays for capital improvements. You are paying for the availability of care in most cases whether or not you actually use the care.

The portion of the monthly fees that is attributable to medical care is deductible as a medical expense. If you itemize deductions, your medical expenses are deductible to the extent they exceed 7.5% of adjusted gross income.

The community determines the portion of the monthly fees that are for medical care and reports this to residents. There are two methods the community can use to compute the fees: the percentage method and the actuarial method. The actuarial method is the one preferred by the IRS. It results in lower deductions for residents and also is more complicated to compute, perhaps increasing the operating expenses of the community.

The good news is that a 2004 Tax Court case shot down the IRS’s position that everyone is required to use the actuarial method. The case allows the use of the percentage method and sets out details how the percentage is to be determined. See our April 2004 issue or the Tax Watch section of the web site Archive for details on this case.

Another aspect of the Tax Court decision is that the cost of pools, spas, and other exercise facilities is not to be included in total expenses when computing the medical expense portion of the monthly fee. The cost of these monthly fees is to be separately reported. Any resident who uses them for medical reasons can deduct his or her share of the cost as reported by the community.

Before enrolling in a facility, you might want to ask which method the community uses to compute the medical expense portion of the monthly fees and what the percentage has been in the past or is projected to be in the future. If possible, get a copy of the information the community gave to its residents in the past and have your tax advisor review it. This can meaningful change your after-tax cost of living there.