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Retirees' Delightful Dividend Decision

It can be expensive to move into a retirement community; the initial entry fee, plus subsequent monthly fees, can total many thousands of dollars. In return for those fees, communities promise their retiree residents lifetime accommodations, meals, and services -- including varying amounts of medical care and treatment. Are any of these fees allowable as a medical expense deduction? The answer is often "yes," but you may have to do a little digging to find your deduction.

For many years, the IRS has allowed citizens who pay these fees to deduct a certain percentage for allowable medical expenses. In most cases, taxpayers can find the percentage of deductible medical expenses by dividing the retirement community's total annual medical expenses by its total annual operating expenses. You can read more about how this method works by reviewing Revenue Rulings 67-185, 75-302, 76-481, and 93-72.

Additionally, Rev. Rul. 76-481 also states that this percentage can be used to compute the amount of medical care for both monthly fees and the up-front "entry fee," even if the actual medical services aren't provided until years later. But a recent Tax Court decision has slightly changed how the percentages are computed.

Here's how the previous method worked: Suppose Jack and Jill move into a retirement community, paying $100,000 in entrance fees and a $2,000 monthly fee thereafter. At the end of the year, the community has spent $2.4 million, 30% of its $8 million total expenses, on medical care. Therefore, in the year they move in, Jack and Jill can deduct $30,000 of their one-time entry fee. In that year and all subsequent years, they can also deduct $600 from each installment of their monthly fees -- assuming that the amount the community spends on medical care remains consistent. (If the community spends 20% or 40% on medical care next year, for example, Jack and Jill will have to deduct that percentage from their monthly fees instead.)

The Tax Court took issue with this formula, feeling that it gave an unfair advantage to single residents and those who signed up for larger or more expensive units. Under the IRS-approved percentage method, those folks would be able to claim higher medical expense deductions only because they pay higher fees. To eliminate this unfair condition, the Tax Court said that the percentage computation should be made on a per-person basis.

To demonstrate how the new method works, let's use the same facts as we did above, with a few additional caveats:

  1. The average entrance fee amounts to $60,000 per person for the year in question.
  2. The average monthly fee amounts to $1,250 per person for the year in question.

Therefore, based upon the Tax Court rules, Jack and Jill's medical deduction for the entry fee would be:

$60,000 (avergage entrance fee) x 2 (people) x 30% (deduction rate) = $36,000

Using the same formula with the $1,250 monthly fee, Jack and Jill can treat $750 of their monthly fees as deductible medical expenses.

In this case, the Tax Court-approved percentage method would be much better for Jack and Jill. That's not always the case, though, depending on how the expenses break down on a per-person basis.

There's good news, though. At present, both the original method and its Tax Court-crafted successor have the approval of the IRS. Unless or until the IRS adopts the Tax Court's method as its official standard, you can calculate your deductions via both methods and use whichever one saves you the most money. If you, a friend, or a loved one live in such a retirement community, make sure to obtain all the information needed to run both sets of numbers and see which deduction pays off best.

When he's not dealing with tax issues, Roy Lewis is a motivational speaker who lives in a trailer down by the river. He understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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