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Things You Need to Know About Reverse Mortgages
A reverse mortgage is a financial product that allows homeowners, typically aged 62 or older, to convert part of their home equity into cash. Unlike a traditional mortgage, where the homeowner makes payments to a lender, in a reverse mortgage, the lender makes payments to the homeowner. This can be done as a lump sum, regular monthly payments, or a line of credit.
The reverse mortgage must be secured by a first trust deed. Thus, any existing loans must be paid off with separate funds or with the proceeds from the reverse mortgage. The amount that can be borrowed is based upon age. The older the borrower, the greater amount that can be borrowed and the lower the interest rate. The rules are complicated and depend upon the type of current debt owed by the potential borrower.
When a reverse mortgage is paid off, there is accrued interest to be paid along with the loan balance payoff and not the usual case, but some of that interest may be deductible. The following includes tax and financial issues associated with reverse mortgages.
Proceeds
Taxability: The funds received from a reverse mortgage, whether in a lump sum, a line of credit, or monthly payments, are considered loan proceeds by the IRS and are not treated as taxable income.
Impact on Social Security and Medicare: Because the payments are not considered income, they will not affect Social Security or Medicare benefits or tax provisions that are based on income.
Limited Interest Deduction
Interest is Deductible Only When Paid: Unlike a traditional mortgage, the interest that accrues on a reverse mortgage is only deductible when the loan is fully repaid, which typically happens when the home is sold, or the last borrower dies.
Form 1098: The lender will issue a Form 1098 to report the interest paid in the year the mortgage is settled.
Loan Purpose Limits Deduction: The deduction is generally only available if the loan proceeds were used to "buy, build, or substantially improve" the home (IRC Section 163(h)(3)). For most reverse mortgage borrowers who use the funds for general living expenses, the interest will not be deductible, even when the loan is repaid.
Accrued Reverse Mortgage Interest: There are several factors to consider in determining whether accrued reverse mortgage interest is deductible and by whom. Equity debt interest has not been deductible since 2017. However, if the reverse mortgage refinanced an existing home acquisition debt, then when the reverse mortgage loan is paid off a prorated portion of the accrued interest will be deductible home acquisition debt interest.
Who Claims the Deductible Accrued Interest: If there is equity interest included, the party who repays the loan can claim the deduction, subject to the conditions above.
o Borrower: If the borrower pays off the loan while still living in the home, they deduct the interest.
o Estate: If the borrower passes away and the estate pays off the mortgage, the estate can deduct the interest on its income tax return.
o Heirs: If the heirs inherit the home and pay off the mortgage, they can deduct the interest on their personal income tax returns.
Deductibility Limitations
Loan Balance Caps: Even if the funds were used for qualifying home improvements, the deduction may be limited by IRS rules concerning home equity debt. The accrued interest is subject to the total debt limits for claiming a home mortgage interest deduction which are $750,000 for loans made after December 15, 2017, and $1mil prior.
Use of Funds Documentation: To support the deduction, careful records must be kept, such as receipts and invoices, proving that the reverse mortgage proceeds were used for home improvements.
Potential Impact on Means-tested Benefits
Risk to Medicaid and SSI: The funds from a reverse mortgage are considered assets. If the borrower receives means-tested government benefits, such as Medicaid or Supplemental Security Income (SSI), holding large amounts of unspent cash can affect their eligibility. To avoid this, it is crucial to spend the proceeds within the same month they are received.
Borrower’s Ongoing Responsibilities
Property Taxes and Insurance: As the homeowner, the borrower is still responsible for paying property taxes, homeowners’ insurance, and any other property expenses. Failing to pay the property taxes and insurance on time, or not maintaining the home, can put the borrower at risk of default and foreclosure
Financial Assessment: Before a prospective borrower can get a loan, a lender will perform a financial assessment to determine how they will pay for these ongoing expenses. If they have a history of late payments, a portion of the loan proceeds may be set aside in a Life Expectancy Set-Aside (LESA) account to ensure these bills are paid.
Considerations for Heirs
Limited Liability: Many reverse mortgages, including all FHA-insured Home Equity Conversion Mortgages (HECMs), are "non-recourse" loans. This means heirs will never owe more than the home's value, even if the loan balance exceeds the sale price. If the loan balance is higher than the home’s market value, FHA insurance covers the difference.
95% Rule: The 95% rule ensures that if the heirs want to keep the home, they can purchase it for 95% of its appraised value or the total loan balance, whichever is lower. This provides a level of financial protection, preventing the heirs from being stuck with a debt larger than the home’s worth.
Capital Gains Tax: Selling a home with a reverse mortgage follows standard capital gains tax rules. Heirs will receive a "stepped-up" basis on the property, which can significantly reduce or eliminate any capital gains tax if the home is sold soon after inheritance.
Drawbacks of Reverse Mortgages
Though reverse mortgages offer financial flexibility, they are not without downsides. As interest accumulates, the loan balance increases over time, diminishing the equity available for both the borrower and their heirs. Additionally, the borrower is still required to cover property taxes, insurance, and maintenance; neglecting these duties can result in foreclosure.
Reverse mortgages also entail fees and closing costs that may be higher than those of traditional loans. For borrowers planning to relocate soon, this may prove to be an impractical choice. Therefore, it's crucial to carefully consider both the advantages and disadvantages.
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