CCRC Fees - A Primer On The Tax Treatment Of Entrance And Monthly Fees

1. Introduction

   Continuing care retirement communities (CCRCs) are professionally managed retirement communities, many of which also function as long-term skilled nursing care facilities. CCRCs offer residents lifestyle amenities and coordinated social activities as well as various degrees of medical care and assisted-living services. CCRCs generally provide residents with progressive levels of care, ranging from independent living to assisted living to skilled nursing care. This tiered-care approach permits residents to increase their level of assistive services as needed, based on changes in their mental or physical health.

   Not all CCRCs are operated in the same manner. For example, skilled nursing services may be offered either onsite or offsite and sometimes are provided through a referral agreement with a third party. The costs associated with residing at a CCRC may vary significantly depending on the continuing care agreement offered by the CCRC.1 Further, some CCRCs allow for sharing of the appreciation or risk of downside in the value of the unit. Thus, there is no one-size-fits-all model for CCRCs.2

   Before entering a CCRC, residents generally execute a continuing care agreement setting forth the terms and conditions of their residence at the CCRC. Under a typical agreement, a resident is required to pay a one-time up-front entrance fee and recurring monthly fees in order to reside at the CCRC. Entrance fees may be refundable in whole or in part if a resident leaves the community or upon the resident's death. Monthly fees generally reflect the cost of operating the CCRC, and can cover items such as meals, housekeeping and laundry services, utilities, maintenance, appliances and emergency services. Unlike entrance fees, monthly fees are generally not refundable. Some states regulate the payment and use of entrance and monthly fees.3

   The dual lifestyle and medical care aspects of many CCRCs lead to questions regarding the tax treatment of fees paid to the facility, both for residents and for the CCRCs. The tax treatment of these fees is discussed below.

2. Tax Consequences to the Resident

   From the perspective of CCRC residents, the relevant questions are whether a resident is entitled to any deductions related to the payment of entrance and monthly fees and whether a resident paying an entrance fee is subject to the imputed interest rules under IRC § 7872. As explained below, it is well established that portions of such fees may be allowed as deductions; however, each situation is fact specific, and there is no clear-cut methodology for determining the appropriate deduction amount. With respect to IRC § 7872, the available guidance indicates that residents who pay entrance fees generally do not have imputed interest income.

   1. Section 213 Medical Care Expenses

      Section 213 allows a taxpayer to deduct any amounts of "medical care" expenses that exceed 7.5 percent of the taxpayer's adjusted gross income.4 "Medical care" is generally defined as amounts paid for the costs of (1) "diagnosis, cure, mitigation, treatment, or prevention of disease, or the for the purpose of affecting any structure or function of the body"; (2) medical-related transportation; (3) qualified long-term care services; and (4) insurance covering medical care or qualified long-term care.5 Several IRS rulings and cases have interpreted IRC § 213 in the context of CCRC fees.

      IRS Guidance

      The IRS first affirmed the appropriateness of IRC § 213 deductions of the medical-cost portions of CCRC fees in a 1966 General Counsel Memorandum,6 advising that it agreed with a proposed letter ruling holding that "[t]he portion of a 'lifetime care fee' allocable to medical care is deductible as a medical expense under section 213, Internal Revenue Code of 1954."7 The memorandum reasoned that the fee was paid pursuant to a legal obligation and assured the residents of lifetime care at no additional cost. The memorandum further advised that the possibility that a portion of the fee could be refunded upon the resident's termination of the contract was not important because any amount refunded would likely have to be included in gross income in the year of refund.

      The following year, the IRS issued published guidance8 allowing a medical expense deduction for the portion of a monthly fee paid to a retirement home attributable to the costs of providing medical care, as calculated "on the basis of the home's experience."9 The IRS adopted the principle from a 1954 Revenue Ruling10 that, where a lump-sum fee is charged for several services and a breakdown can be provided showing the amount allocable to medical care, a deduction may be allowed based on that amount.

      In 1975, the IRS expanded on these principles by publicly ruling that CCRC residents may deduct the medical portions of CCRC fees in the year of payment even if some amounts may be refunded in later years.11 In consideration for a CCRC's promise of lifetime care, the resident taxpayer made a lump-sum payment, which assured the resident lifetime care at no additional cost. In the event the resident terminated the agreement, the resident would have a conditional right to a partial refund of the life-care fee. Despite the potential for partial refund, the IRS ruled that a portion of the fee was an expense for medical care, because the CCRC demonstrated that it was to cover the obligation to provide medical care and gave the resident a separate statement to that effect. However, the IRS also ruled that any portion of the life-care fee actually refunded to and received by the taxpayer in a later year would have to be included in gross income to the extent attributable to prior deductions.12 The IRS reached the same conclusion the following year, ruling that taxpayers could deduct a portion of the fee that was made in return for the promise to provide lifetime care.13 It also reaffirmed the use of long-term experience of CCRC facilities in determining the appropriate percentage of entrance and monthly fees attributable to medical expenses.

      Since 1975, the IRS has consistently ruled in private guidance that portions of monthly and entrance fees shown to be attributable to medical care and expenses are deductible to the extent allowed under IRC § 213.14 As discussed below, the dispute in recent years has turned to what costs are attributable to medical care and whether any portion of an entrance fee is attributable to such care.

      1 Case Law

      The Tax Court first addressed the deductibility of entrance fees in Est. of Smith.15 There, the taxpayer agreed to pay an entrance fee of $20,460 and a monthly fee of $280 in exchange for a lifetime lease of an apartment at a retirement facility. Pursuant to the terms of the residency agreement, the facility agreed to provide services such as medical insurance, carpets, laundry, appliances, maintenance and utilities. A resident was entitled to 30 days' standard care at a convalescent and rehabilitation center, plus 10 additional days of such care for each full year of continuous residency. The taxpayer moved into the facility in 1976, immediately became sick and was moved to the center for the next two years until he died. A medical expense deduction was claimed based on the full amount of the entrance fee. The IRS determined that no deduction was allowable with respect to the entrance fee, but that a small amount was deductible with respect to other payments that reflected the cost of providing medical insurance.

      The Tax Court found that the retirement community provided no direct medical services, the convalescent center was a separate establishment, and the taxpayer did not move into the facility for medical care. It therefore concluded that, to the extent the entrance fee was for lodging and other services provided to residents of the retirement community, it was not deductible. However, the court found that 7 percent of the entrance fee, which the parties agreed was attributable to the promise to provide free days of care in the convalescent center, was deductible in the year of payment and not, as the IRS argued, in the year services were actually rendered. The court reasoned that the obligation to pay the fee was incurred at the time the agreement was entered into and was in return for the community's promise to provide not only lifetime lodging and various services, but also free medical care. The IRS has acquiesced in Est. of Smith.16

      In Finzer,17 the Northern District of Illinois recently addressed the deductibility of entrance fees in a refund context. There, the taxpayers had originally deducted 18.9 percent of their 90 percent refundable entrance fee. They subsequently filed an amended return seeking a refund based on a deduction equal to 41 percent of the entrance fee. Because the limitations period for disallowing the amount deducted on the original return had expired, the sole issue was whether the taxpayers could prove that they were entitled to deduct any amount above what was claimed on their original return. The district court interpreted the residency agreement as providing that the entrance fee did not relate to medical care; rather, it was the monthly fee that covered the medical expenses. It found that the entrance fee was structured as a loan and that the CCRC "always" returned at least 90 percent of the entrance fee. The court ultimately concluded that "because the entrance fee is a loan, it cannot serve as the basis for a deduction for the Finzers," and therefore no additional medical expense deduction was allowable.18 The district court also distinguished prior rulings because it believed that portions of the entrance fees in those rulings "may" have been refundable, as opposed to the situation before it where a portion "would" have to be refunded.19

      The Tax Court recently addressed the deductibility of monthly fees in Baker.20 Given the IRS's consistent position (which it adhered to in that case) that a medical expense deduction may...