Tax Consequences of Continuing-Care Retirement Community Fees

By Sarah L. Mayes and Linda L. Nelms

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MAY 2007 - Increasing evidence shows that baby boomers are more willing to plan for their long-term care than their parents were. They expect a postretirement period well in excess of what previous generations expected, due in part to increased life expectancy and to early-retirement options. Many are less concerned about leaving an estate and more concerned about supporting themselves throughout an extended period of retirement.

The options they are likely to consider include a continuing-care retirement community (CCRC), a facility that provides residents with housing and services that serve them from independent living through end of life. Residents sign a detailed contract that allows for changing needs and, as a result, different levels of services and housing over time. The typical CCRC has three distinct levels: independent living, assisted living, and skilled care. Independent living is for residents who can see to their own needs and enjoy the amenities of the facility. Assisted living provides residents with support for the activities of daily living based on their individual needs. Skilled care provides assistance for residents who need skilled nursing services.

While all CCRCs provide residents with increasing levels of services as their need for care increases, there are roughly three types of CCRCs, categorized mainly by the amount of healthcare covered in the agreement and how and when the resident pays for the healthcare. Categories include Type A (extensive contract), Type B (modified contract), and Types C and D (fee-for-service contracts). The cash outflows associated with these options are entrance fees and monthly fees. The category of the facility affects the tax consequences for an individual.

Type A: Extensive Agreements

In an extensive, also called a Type A, full-risk, or life-care agreement, an individual pays a sizable entrance fee and monthly fees for the length of tenure at the facility. The monthly fee will increase based on operating expenses incurred by the CCRC but will not increase based on a change in level of services provided. A portion of the entrance fee and the monthly fees in this kind of facility include payment for prepaid healthcare, which qualifies as a medical deduction under IRC section 213.

The amount of the deductible can be calculated by two methods: the percentage method or the actuarial method. The IRS has always supported an actuarial calculation based on healthcare utilization and longevity. As an alternative, the percentage method calculates the facility’s medical expenses as a percentage of total expenses. The Tax Court in D.L. Baker v. Comm’r [122 TC 143, Dec. 55, 548 (2004)] upheld the use of the percentage method calculated on an allocation percentage based on the number of community residents and the weighted-average monthly service fees. The CCRC is responsible for determining the amount of the entrance fee and the monthly fee that should be allocated to prepaid healthcare and is, therefore, deductible. Taxpayers and their advisors should know when considering a Type A facility that the taxpayer is entitled to this deduction and that the facility should provide the information annually.

An advisor can suggest the optimal time to pay the entrance fee. An individual who has decided to enter a CCRC and has the flexibility to select the date of entrance should consider in which year (or at what time of year) the deduction for the prepaid healthcare will have the most significant impact on tax savings. An individual who enters a CCRC in January will accumulate more monthly healthcare deductions than one who enters later in the year. An additional tax planning opportunity exists to time other elective itemized deductions, such as charitable donations and other medical expenses. Taxpayers and their advisors must also consider the potential impact of alternative minimum tax on these deductions.

While the amount of the monthly fee does not increase when the resident of a Type A facility enters the assisted-living or the skilled-care phase, the amount of the deduction increases because a larger proportion of the monthly fee goes toward medically related expenses.

Type C and Type D: Fee-for-Service Agreements

On the other end of the range of options, the fee-for-service arrangement may have no healthcare prepayments. In the Type C facility, there is an entrance fee and there are monthly fees in independent living, but they may not include an element of prepaid healthcare, so there would be no deduction associated with either the entrance fee or the monthly fees. The Type D contract does not have an entrance fee at all. As a result of the decision in D.L. Baker v. Comm’r, some Type C facilities are notifying their residents of the possibility of a healthcare deduction. The facility is using a percentage method to allocate a portion of the actual healthcare expenses the CCRC has incurred, as compared to the total expenses. They are providing that information to residents as a possible medical deduction with no guarantee.

If the resident moves to assisted living, the monthly fees are automatically increased, and a move to skilled care results in still higher monthly fees. The individual or advisor must determine what portion of assisted-living cost increases is related to healthcare. Skilled-care services are healthcare related and are tax deductible.

Type B: Modified Agreements

An intermediate category between extensive contract and fee-for-service is called a modified, Type B, or partial risk arrangement. The tax consequences may be less clear than with either Type A or fee-for-service CCRCs. Type B facilities may or may not recognize a healthcare component in their entrance fee or monthly fees. The resident pays higher monthly fees when more healthcare services are needed. Type B CCRCs differ from fee-for-service facilities, however, because their contracts carry some kind of financial benefit in terms of assisted living or skilled care. For example, one Type B facility might allow residents a specific number of days’ stay in assisted living or skilled care before the monthly fee is increased. Another facility might guarantee a discount from the market-driven price for assisted living or skilled care.

The controller at the facility can provide the information necessary to determine what portion of fees, if any, are allocable to prepaid healthcare. The Exhibit summarizes the differences among CCRCs.

Direct Admissions

If space is available, some Type A or Type B facilities will accept individuals directly into assisted living or skilled care, rather than the typical initial entry into an independent living arrangement. The individual accepted under this direct admission process may be required to pay an entrance fee. This entrance fee is nondeductible if it is to admit the resident into assisted living, unless the entrance fee covers future rights for medical care in skilled care.

So-called direct admissions will pay a higher monthly fee than those who have been life-care admissions to Type A facilities. A resident who enters a modified agreement (Type B) facility as a direct admission will pay more in monthly fees than a resident who enters under an admission contract that offers the discounted skilled-care services. The housing and medical costs associated with skilled care will be tax deductible, however.

Assessing the deductibility of assisted-living monthly fees requires reference to IRC section 7702B(c) and Notice 97-31, which define “chronically ill.” This definition is crucial to the deductibility of the monthly fees because certain tax deductions that exist if the taxpayer enters assisted living as a chronically ill individual do not exist if the taxpayer enters for basic custodial care. To qualify as chronically ill, an individual must be certified by a licensed healthcare provider as unable to perform (without substantial assistance) at least two “activities of daily living” (eating, toileting, transferring, bathing, dressing, and continence) for at least 90 days due to a loss of functional capacity, or must require substantial supervision for protection due to severe cognitive impairment.

Equity Model Facilities

An additional option on the CCRC menu is the equity model. Residents of this kind of facility “buy” their original dwelling in the CCRC. When they vacate it, the unit is available for a new resident and the proceeds from the next resident’s deposit, up to the amount of the “owner’s” original entrance fee, revert to the resident or the resident’s heirs. Because the entrance fee is basically a deposit on a unit, there is no tax saving relating to healthcare. Taxpayers and advisors must carefully examine the contract to determine if it has any potential tax consequences.

Tax-Bracket Implications

Additional planning opportunities exist in timing the payment of the entrance fees and the liquidation of investments. If an individual enters the facility early in the year, the tax-deductible portion of the entrance fee added to the monthly fees attributable to healthcare may result in significant itemized deductions. The deductions might reduce taxable income to a level that will result in the taxpayer’s capital gains and qualifying dividends being taxed at a rate of 5% rather than 15%.

Sarah L. Mayes, CPA, MBA, is a lecturer, and Linda L. Nelms, CPA, CMA, MBA, is a professor, both in the department of management and accountancy at the University of North Carolina Asheville, Asheville, N.C.




















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