Baker

*144 GOEKE, Judge: Respondent determined deficiencies in petitioners' Federal income taxes of $ 983 and $ 1,252 for the taxable years 1997 and 1998, respectively. After a concession, ¹ the issues for decision are: (1) What portions of monthly services fees paid by petitioners for lifetime residence at a continuing care retirement community are allocable to medical care under section 213; ² and (2) whether petitioners are entitled to deduct additional amounts under section 213 for medical use of pool, spa, and exercise facilities at the retirement community. We hold that the portions of the monthly service fees paid by petitioners for medical care were $ 7,766 and $ 8,476 for 1997 and 1998, respectively. We further hold that petitioners are not entitled to any deductions for 1997 and 1998, respectively, for the use of the pool, spa, and exercise facilities.

*16              FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts and the attached exhibits are incorporated herein by this reference. Petitioners, Mr. Baker and Mrs. Baker, resided in Riverside, California, at the time they filed their petition.

On December 22, 1989, petitioners and Air Force Village West, Inc. (AFVW) executed a residence agreement entitling petitioners to a lifetime residence at Air Force Village West (Village West). AFVW is a nonprofit organization that was incorporated in the State of California on September 21, *145 1984. AFVW was organized to establish, maintain, endow, and operate continuing care retirement communities (CCRCs) for officers (and their spouses and qualified dependents) of the U.S. uniformed services who are more than 60 years old and have been retired or honorably separated from active duty. Village West is one of the CCRCs owned and operated by AFVW. Village West is a gated, guarded, perimeter-fenced, resortlike retirement community located on 153 acres of land in Riverside, California.

The construction of Village West occurred*17 in three phases. The first phase involved the construction of the following living units and health care facilities: (1) Independent Living Unit (ILU) apartments, duplexes, and cottages; (2) an Assisted Living Unit (ALU) facility with 20 rooms; (3) a Skilled Nursing Facility (SNF) with 59 beds; (4) a Commons building with a suite of rooms set aside, in part, for an outpatient medical services clinic; (5) an F-Wing of apartment units; (6) a G-Wing of apartment units; (7) a pool area with Jacuzzi; (8) a maintenance and housekeeping building; (9) a mechanical building; and (10) an outside courtyard. The first phase was substantially completed in December 1989, and initial operation began, and the first residents moved in, at that time.

The second phase of the construction of Village West involved the construction of the following additional housing, administration, and maintenance buildings: (1) A landscape building; (2) administrative offices located at the Commons building; and (3) additional ILU cottages. The second phase was completed in October 1993 and started operation at that time.

The final phase of the construction of Village West involved the expansion of the existing ALU*18 facility and the construction of a new Special Care Unit (SCU) facility. The final phase was completed in June 1997 and started operation at that time.

Village West provides the following four different levels of living accommodations: (1) Independent living, or ILU; (2) *146 assisted living, or personal care (previously referred to as ALU); (3) special care, or SCU (Alzheimer's/Dementia unit); and (4) skilled nursing, or SNF. The ALU, SCU, SNF, and outpatient medical services clinic are located in one building which also houses the administrative offices of AFVW, the dining room, and apartment units. This building is known as the Village West Health Center and is also called the Commons building. During the years in issue, the Village West Health Center was available for patient use by both residents of Village West (hereinafter sometimes referred to as AFVW residents) and nonresidents of Village West who lived in the surrounding community (hereinafter referred to as noncontract patients). Noncontract patients were charged higher rates for use of the Village West Health Center and certain services were billed to them on a fee- for-service basis.

*19 1. Independent Living Units

The ILU apartments, duplexes, and cottages are designed for normal, everyday independent living of AFVW residents, and resemble regular residences that can be found in any nonretirement living community. All ILUs are initially equipped with miniblinds, wall-to-wall carpeting, and standard kitchen appliances. These are paid for by AFVW.

During 1997 and 1998, several amenities were available to AFVW residents living in the ILUs, including: (1) An emergency-pull- cord system installed in each ILU; (2) complete building and grounds maintenance; (3) weekly housekeeping services; (4) a 24-hour front desk service; (5) access to a fitness center, available for medical therapy, with spa and exercise areas; (6) an indoor/outdoor swimming pool and Jacuzzi; and (7) complete patient access to all on-campus health services provided in the Village West Health Center. Beginning in June 1997, AFVW residents living in ILUs gained access as patients to the newly opened SCU also located in the Village West Health Center.

The front desk is staffed 24 hours a day and is the focal point for information, service, and assistance to residents. One of the duties of the front desk*20 was monitoring and responding to the emergency-pull-cord system installed in the ILUs and other areas of AFVW where the system is in place. The emergency-pull-cord system was connected *147 directly to the front desk and a crisis nurse, an assistant, and a security guard would be dispatched to the ILU if necessary.

During the years in issue, Mr. Baker used the pool, spa, and exercise facilities at Village West. Petitioners, like other AFVW residents, were not charged a separate fee to use these facilities.

2. Assisted Living Units

The ALU facilities represent an intermediate step between independent living and the need for a higher level of care; i.e., skilled nursing care. The ALUs are designed for two types of individuals. They are designed for individuals who are unable to leave a building unassisted under emergency conditions, including but not limited to, individuals who depend on mechanical aids such as crutches, walkers, and wheelchairs and who are unable or likely to be unable to respond physically or mentally to an emergency situation such as a fire. The ALUs are also designed for individuals who need care and supervision with the activities of daily living, such as eating, *21 bathing, and dressing. The ALUs are designed to provide occupants with a comfortable, homelike atmosphere where they are encouraged to provide their own furniture, bedding, and linens.

*148 During the years in issue, both AFVW residents and noncontract patients occupied rooms as patients in the ALU facilities. AFVW residents who became patients in the ALUs received a 60-percent discount off the regular rate charged to noncontract patients who occupied similar units as patients.

3. Special Care Units

The SCU at Village West is a special unit designed to provide living accommodations to individuals with diagnosed Alzheimer's disease and/or similar forms of irreversible dementia. Admission is based strictly on doctor's orders. The SCU is fully enclosed, can only be accessed through a security-locked door, and is manned 24 hours per day by nursing staff members. Patients in the SCU are provided the same services as the individuals occupying the ALUs. Additionally, other programs are provided which are specially geared to enhancing the dignity and lifestyle of patients during the remainder of their lives.

During the years in issue, both AFVW residents and noncontract patients occupied rooms*22 as patients in the SCU. AFVW residents who became patients in the SCU received a 60-percent discount off the regular rate charged to noncontract patients who occupied similar units as patients.

4. Skilled Nursing Care

The SNF at Village West provides the highest level of care of all the health care facilities located at Village West. Admission to this facility is based strictly on doctor's orders. The accommodations provided in the SNF include a skilled nursing facility bed, 24-hour nursing care, and three meals per day. In addition, occupants of the SNF receive services such as long-term maintenance care, necessary diagnostic care, preventative care, therapeutic care, and rehabilitative care required by the chronically ill.

During the years in issue, both AFVW residents and noncontract patients occupied rooms as patients in the SNF. AFVW residents who became patients in the SNFs received an approximately 50-percent discount off the regular rate charged to noncontract patients who occupied similar units as patients.

Petitioners chose a 1,427-square foot, two bedroom, two bathroom, duplex unit for their ILU accommodations. Under the residence agreement*23 executed on December 22, 1989, they were required to pay certain fees in exchange for a lifetime residence at Village West. Petitioners were required to pay: (1) A nonrefundable processing fee of $ 500; (2) an entrance fee of $ 130,015; and (3) an initial monthly service fee of $ 1,418, which was subject to annual increases by AFVW. ³ The residence agreement states that in the case of two individual AFVW residents, the entrance fee is considered paid one-half by each. Petitioners deducted $ 34,541 of the entrance fee as a medical expense on their jointly filed 1989 *149 tax return. ⁴ Petitioners paid monthly service fees to AFVW of $ 2,170 and $ 2,254 for 1997 and 1998, respectively.

*24 Under the terms of the residence agreement, petitioners were guaranteed several amenities in exchange for their payment of monthly service fees, including: (1) The emergency-pull-cord system; (2) 24-hour availability of a licensed nurse from the SNF to respond to medical emergencies; (3) outpatient and other nonlife-threatening nursing services provided at the Village West Health Center outpatient medical services clinic by their nursing staff; and (4) a guaranty from AFVW of a bed in the Village West units or SNF and that the fees charged for use of the unit or the facility would be at a reduced rate from the standard fees charged to noncontract patients occupying such facilities. The residence agreement is silent as to the amount of the fee reduction for use of the units or the facility.

Under the terms of the residence agreement, AFVW could require that petitioners be transferred to a different level of living accommodation if certain medical conditions existed. Additionally, the terms of the agreement provided that petitioners were entitled to lifetime care.

A. AFVW's Financial Information for*25 1997 and 1998

In a report entitled "Air Force Village West -- Health Facility Information" (hereinafter referred to as the report or the Health Facility Information report), Charles L. Dalton (Mr. Dalton), vice president of finance for AFVW, certified that financial information, allocation tables, and supplemental accounting data contained in the report had been compiled from the accounting records of AFVW. The report included information for the years ended December 31, 1997, and December 31, 1998.

The following chart represents various revenue and expense items for 1997 listed in the report:

*150               REVENUES

Description                        Amount

Monthly fees                      $ 7,979,906

Entrance fee revenue                   2,978,303

Entrance fee terminations                  551,616

Resident ALU fees                      301,321

Noncontract patient ALU fees                 80,156

Resident SCU fees  *26                     55,445

Noncontract patient SCU fees                 3,640

Resident SNF fees                      470,787

Noncontract patient SNF fees               1,207,747

Investment income                     2,890,228

Gain from sale of securities                107,335

Net, direct billings                    355,185

              EXPENSES

Description                        Amount

Total operating expenses                $ 16,069,104

Total interest expense                  4,797,339

Total depreciation and amortization            2,161,331

Total issue cost                       98,395

Total environmental services               1,028,776

SNF expenses                   *27     3,044,041

ALU and SCU expenses                    929,275

Various SNF revenue and expenses for 1997 were listed as follows:

              REVENUES

Description                        Amount

Description Amount

SNF room and board, private/Medicare/           $ 795,567

   HMO fees for residents

SNF room and board, private/Medicare/           1,207,747

   HMO fees for noncontract patients

SNF ancillary services, Medicare/HMO            365,444

   billings for residents

SNF ancillary services, Medicare/HMO            448,462

   billings for noncontract patients

              EXPENSES

Description                        Amount

Direct Expenses:

   Food service                     $ 163,348

   Payroll and benefits                 1,342,771

   Departmental costs            *28        214,727

  *151 Patient charges                    726,229

Purchased Services:

   Housekeeping and laundry                99,092

   Food service (benefits)                 22,106

   Maintenance                       39,316

   Landscape                        29,833

   Administration                     123,011

   Insurance                        21,970

   Linens                          8,403

   Depreciation and amortization             211,343

   Contracts                        8,206

   Utilities                        33,686

   Total expenses                    3,044,041

The following chart represents various revenue and expense items for 1998 listed in*29 the report:

              REVENUES

Description                        Amount

SNF room and board, private/Medicare/           $ 585,802

   HMO fees for residents

SNF room and board, private/Medicare/           1,315,694

   HMO fees for noncontract patients

SNF ancillary services, Medicare/HMO            315,969

   billings for residents

SNF ancillary services, Medicare/HMO            378,905

   billings for noncontract patients

              EXPENSES

Description                        Amount

Total operating expenses                $ 17,759,058

Interest expense                     4,669,121

Depreciation and amortization               2,321,300

Issue costs                         107,134

Total environmental services               1,030,677

SNF expenses  *30                      3,330,031

ALU expenses                        984,333

SCU expenses                        796,306

In a separate document (hereinafter referred to as the 1998 financial document) that should have been included in the Health Facility Information report because it represents *152 the most accurate data, the following relevant revenue and expense items were listed for 1998:

              REVENUES

Description                        Amount

Monthly fees                      $ 8,329,241

SNF noncontract patient fees               1,301,382

ALU noncontract patient fees                104,083

SCU noncontract patient fees                110,202

              EXPENSES

Description                        Amount

Total operating expenses       *31          $ 16,986,770

Interest expense                     4,704,320

Depreciation and amortization               2,338,558

Issue costs                         107,134

Total environmental services               1,020,109

Various SNF expenses for 1998 were listed in the Health Facility Information report as follows:

              REVENUES

Description                        Amount

SNF resident fees                     $ 585,802

SNF noncontract patient fees               1,315,694

SNF Medicare/HMO billings for residents           315,969

SNF Medicare/HMO billings for                378,905

   noncontract patients

SNF other                          15,696

Home care                          49,578

            *32   EXPENSES

Description                        Amount

Direct Expenses:

   Health services - payroll and benefits        $ 374,008

   SNF - payroll and benefits               964,802

   Clinic - payroll and benefits             120,955

   SNF - departmental expenses              197,028

   Clinic - departmental expenses             40,446

   Patient chargeables                  677,894

   Depreciation                      166,303

   Insurance                        32,531

   Utilities                        26,073

   Contract                         3,055

*153 Purchased Services:

   Corporate administration                125,684

   Environmental services                 144,295

   Food services   *33                   381,040

   Maintenance                       36,111

   Landscaping                       30,306

   Linens                          9,500

   Total expenses                    3,330,031

Similar charts were included detailing an allocation of expenses to the ALU and SCU. The report states that the SNF, ALU, and SCU expense information listed above does not include an allocation of amortization of debt issue cost, amortization of preopening cost, or an allocation of interest expense. Specific expenses associated with the pool, spa, and exercise facilities at Village West are not identified in the financial information in the report.

In allocating expenses to the SNF, the following explanation was provided:

Line Item                       Description

Food service                  Percent of total contract

Payroll and benefit              Direct labor*34 costs plus benefits

Departmental costs               All expenses in specific dept.,

                       except payroll and benefits

Housekeeping and laundry            Percent of total contract

Food service                  Benefits of employees directly

                       allocated to cost center

Maintenance                  A specific employee dedicated to

                       the health care facility

Landscape                   Based on previous time study

Administration                 Based on previous time study

Insurance                   Policies directly related to

                       facility plus 10 percent of

                       other policies

Linens                     Linens purchased*35 directly

                       for the SNF

Depreciation and                Directly from the fixed asset

amortization                  program

Contracts                   Alarm system, copiers, fire

                       drill, Medical Director, etc.

                       (No ancillary contractors)

Utilities                   10 percent of the total

                       utilities for AFVW

Interest expense                10 percent of total interest

                       expense for AFVW

The explanation notes that allocations for ALUs and SCUs are the same except for maintenance, landscaping, administration, insurance, contracts, utilities, and interest, which were allocated on the basis of two-thirds of the SNF costs.

*154 The report contains an allocation of costs to the emergency-pull-cord system for*36 ILUs for 1998. ⁵ The cost was determined by developing an average hourly rate for front desk staff monitoring the system, multiplying this by the number of hours in a year (because the system was monitored 24 hours a day), and then adding an overhead cost factor of 30 percent of the staff cost. On the basis of an average hourly rate of $ 7.75, the total cost to monitor the emergency-pull-cord system for ILUs was determined to be $ 88,257. ⁶ Mr. Dalton calculated this allocation.

*37 The report contains revenue totals for 1997 and 1998 for monthly services fees from ILU residents. For 1997, the total monthly service fees from ILU residents are listed as $ 7,979,906. For 1998, the report lists total monthly service fee revenue of $ 8,327,083. The report also shows average census figures for the ILUs for 1997 and 1998. The schedule reflects that for 1997 there were 372 occupied ILUs containing 574 residents. For 1998, there were 386 occupied ILUs containing 591 residents.

On behalf of AFVW, Mr. Dalton calculated the deductible portion of the monthly service fees paid in 1997 and 1998 for AFVW residents living in ILUs. Mr. Dalton informed ILU residents of his calculations and advised them to consult their tax adviser for possible application on their tax returns. The general approach utilized by Mr. Dalton was to use costs associated with the SNF in determining the medical expense attributable to ILU residents. Some of the figures used by Mr. Dalton to calculate the allocation percentage are different from those outlined in the Health Facility Information report.

*155 1. Calculation of 1997 Medical Expenses

For 1997, Mr. Dalton used a*38 percentage method to determine the proper allocation of monthly service fees to medical care. Mr. Dalton calculated the allocation percentage by determining the total expenses associated with the SNF and subtracting from this figure depreciation, interest expense, and Medicare and HMO insurance reimbursements allocable to the SNF. ⁷ He then divided this amount by the total costs, excluding total depreciation and interest expense, of Village West. Mr. Dalton calculated that 17.78 percent of the total monthly service fees paid by residents living in ILUs were allocable to medical care. Applying slightly different residency and monthly service fee figures than those contained in the Health Facility Information report, Mr. Dalton concluded that the portion of monthly service fees for ILU residents that was allocable to medical care was $ 374 per residence per month.

2. Calculation of 1998 Medical Expenses

In 1998, *39 AFVW switched to an actuarial method to determine the deductible portion of monthly service fees. ⁸ However, Mr. Dalton still prepared a calculation for that year using the percentage method so that AFVW residents joining the community prior to January 1, 1998, would have information comparable to prior years for tax return preparation. Using the same methodology as in 1997, Mr. Dalton calculated that 19.01 percent of the total monthly service fees paid by residents living in ILUs were allocable to medical care. Applying slightly different residency and monthly service fee figures than those contained in the Health Facility Information report, Mr. Dalton concluded that the portion of monthly service fee for ILU residents that was allocable to medical care was $ 416 per residence per month.

C. Ad Hoc Committee's Calculation of Medical*40 Expenses

In 1997, the resident council of Village West established an ad hoc committee (hereinafter sometimes referred to as the *156 committee) to recalculate what portion of the monthly service fees paid by residents living in ILUs should be allocated to medical care. The ad hoc committee reported to the resident council. Petitioner was a participant of the ad hoc committee. In February 1998, Mr. Dalton supplied the resident council with information for purposes of determining the appropriate medical deductions for ILU residents for 1997 and 1998. ⁹

In a letter dated March 13, 2000, the ad hoc committee reported to the resident council its findings regarding income tax deductions for ILU residents for health care expenses. Using the percentage method, the committee calculated that the portions of monthly services fees allocable to medical care were 40.3 percent and 41.6 percent*41 for the years 1997 and 1998, respectively. In calculating total operating expenses, the committee subtracted interest expense, depreciation and amortization, issue cost, and noncontract patient expenses from total AFVW expenses. In calculating medical expenses, the committee included SNF, ALU, and SCU operating expenses, and subtracted out noncontract patient fees and depreciation and amortization allocable to the three facilities. The committee then made certain upward adjustments to account for the emergency-pull-cord system, food service, environmental service, utilities, and insurance. The adjustments for food service and environmental expenses were based on formulas provided by the food service contractor and the environmental service contractor. The adjustment for utilities was based on a square-footage method and the adjustment for the insurance was based on a ratio- and square-footage methodology.

The following chart prepared by the ad hoc committee represents its calculations for 1997:

   Operating Expenses                Amount

Total expenses                  $ 16,069,104

Interest expense   *42                (4,797,339)

Depreciation and amortization            (2,161,331)

Issue cost                       (98,395)

Noncontract patient expense             (1,291,543)

 Total operating expenses              7,720,496

   *157 Medical Expenses                 Amount

SNF operating expenses               $ 3,044,041

ALU and SCU operating expenses             929,275

Emergency pull-cord system               87,374

Food service adjustment                482,769

Environmental service adjustment            112,617

Utilities adjustment                  81,146

Insurance adjustment                  18,234

SNF noncontract patient fees            (1,207,747)

SNF depreciation and amortization           (211,343)

ALU noncontract patient fees              (80,156)

SCU*43 noncontract patient fees              (3,640)

ALU and SCU depreciation and amortization       (140,895)

 Allocable medical expenses             3,111,675

Dividing medical expenses by total operating expenses, the committee calculated that the allocation percentage for 1997 was 40.3 percent. ¹⁰

The following chart prepared by the ad hoc committee represents its calculations for 1998:

     Operating Expenses              Amount

Total expenses                   $ 16,986,770

Interest expense                   (4,704,320)

Depreciation and amortization            (2,338,558)

Issue cost                       (107,134)

Noncontract patient expense             (1,515,667)

 Total operating expenses    *44           8,321,091

     Allocable Medical Expenses          Amount

SNF operating expenses               $ 3,330,031

ALU and SCU operating expenses            1,780,639

Emergency pull-cord system                88,257

Utilities adjustment                  103,641

SNF noncontract patient fees             (1,301,382)

SNF depreciation and amortization           (166,303)

ALU noncontract patient fees              (104,083)

SCU noncontract patient fees              (110,202)

ALU and SCU depreciation and amortization       (161,071)

 Allocable medical expenses             3,459,527

The operating expenses figures used by the committee were taken from the 1998 financial document that should have been included in the Health Facility Information report, not from the figures actually contained in the report. Dividing medical expenses by total operating expenses, the committee *158 calculated that the allocation*45 percentage for 1998 was 41.6 percent. ¹¹

In a memorandum dated March 15, 2000, the resident council reported to AFVW residents a summary of the ad hoc committee's findings. Attached to the memorandum was a chart showing that the annual deduction could be calculated by dividing total monthly service fees for the year by 12 months to arrive at the total average monthly service fees paid by ILU residents per month. This amount is then divided by the number of ILU residents shown in the census chart, resulting in the average monthly service fee per resident. Multiplying the average monthly service fee by the allocation percentage provides the medical deduction per resident per month. The chart contained the following information relevant to monthly service fees for ILU residents for 1997 and 1998:

      Independent Living Units

Year    Number Occupied    Residents    Total Yearly Service Fee

____    _______________    _________  *46   ________________________

1997      372         574        $ 7,979,906

1998      386         591         8,329,241

In a memorandum to AFVW residents dated February 1, 2002, the resident council, in conjunction with AFVW management, provided information to residents regarding income tax deductions for health care expenses. The memorandum states that management changed from the percentage method to the actuarial method in 1998 to determine the allowable deduction, and that management planned to continue to use the actuarial method for new residents. It is noted that the actuarial method will produce a different deduction than the percentage method, and individual residents are advised to analyze each method and select the one most beneficial for his or her tax situation.

The memorandum further states that for the years 1997, 1998, and 1999, the ad hoc committee had coordinated and worked with AFVW management to review and make recommendations regarding the portion of monthly service fees allocable to medical care. In addition, the memorandum *159 states that certified data from the financial records of AFVW*47 for these years was provided to the ad hoc committee and that data was used to determine the appropriate allocation percentage. The allocation percentage is listed as 40.3 percent and 41.6 percent for the years 1997 and 1998, respectively. The memorandum then states that the portion of the monthly service fees allocable to medical care is determined per resident. AFVW residents were advised to consult their tax adviser for possible application of the information contained in the memorandum, and it is stated that neither AFVW nor the resident council is a tax adviser. The memorandum is signed by the chairman of the resident council and the president/CEO of AFVW.

On their jointly filed 1997 and 1998 Forms 1040, U.S. Individual Income Tax Return, petitioners reported medical and dental expenses of $ 12,743 and $ 16,828, respectively. ¹² Of these amounts, $ 6,557 and $ 9,891 for the years 1997 and 1998, respectively, related to the portion of the monthly services fees paid allocable to medical care. These amounts are primarily derived from the ad hoc committee's calculations. The amounts of $ 3,461 and $ 3,596 for the years 1997 and 1998, respectively, *48 related to Mr. Baker's use of the pool, spa, and exercise facilities at Village West. The remainder of the reported amounts was for various other items.

Petitioners' claimed entitlement to deductions for Mr. Baker's use of the pool, spa, and exercise facilities is based in part on a letter dated July 29, 1991, from Elaine K. Jones, M.D., which states that her evaluation confirms Mr. Baker's previous diagnoses of hypertension, valvular heart disease, hyperlipidemia, and degenerative arthritis. The letter states that to treat the above medical conditions it is imperative that Mr. Baker continue his exercise program, including the exercise room, swimming pool, and whirlpool at least three times a week. The letter also states that the exercise program will help alleviate the symptoms of Mr. Baker's chronic illnesses.

*160 IV. Respondent's Determination

The examination in this case commenced after July 22, 1998. On*49 September 28, 2001, respondent issued a notice of deficiency to petitioners for their 1997 and 1998 taxable years. In the notice, respondent determined that the portion of the monthly service fees attributable to medical care was limited to $ 4,488 and $ 5,142 for the years 1997 and 1998, respectively. ¹³ Respondent's determination for 1997 was based on Mr. Dalton's determination that $ 374 of the monthly service fees per residence in an ILU was allocable to medical care. ¹⁴ The determination for 1998 was calculated by multiplying the 19.01-percent all