Taxable? Deductible? Income or not? Tax Planning? These questions rise to the surface every year around this time.
It’s tax season. For both new and prospective reverse mortgage borrowers it brings to mind questions about how the money from a reverse mortgage is best handled from a tax perspective. In either case, there are a few things you should know from a tax perspective.
Reverse mortgages enable senior homeowners age 62 and older to borrow against their home equity in exchange for tax-free loan proceeds. These proceeds, which can be used however the borrower chooses without restriction, can be accessed in a single lump sum, monthly installments or a line of credit. Most of the reverse mortgages on the market today are insured by the Federal Housing Administration and are known as Home Equity Conversion Mortgages (HECM).
When you move from the home, the loan balance must be repaid. If you sell your home and use the proceeds to repay the loan, then you or your heirs may receive any proceeds from the home sale that exceed the loan balance. This is one of the key advantages of a HECM over a traditional home equity line of credit (HELOC). Also, unlike a HELOC, the lender cannot freeze, reduce or cancel the reverse mortgage line of credit as long as you remain current on property taxes and homeowner’s insurance payments.
“The proceeds received from a reverse mortgage are not considered income and they are not considered as income for tax purposes.”
You may hear people or advertisements referring to the money obtained from a reverse mortgage as “income.” In fact, this is incorrect. The proceeds received from a reverse mortgage are not considered income and they are not considered as income for tax purposes. Rather, they are loan advances, and as such, are not subject to federal and state income tax.
“The fact that you are taking cash equity out of your home does not go into the realm of income, and therefore, does not enter the realm of taxation,” says Mike Gruley, a certified reverse mortgage professional (CRMP) with 1st Financial Reverse Mortgages, a Division of Success Mortgage Partners, in Plymouth, Michigan.
Furthermore, reverse mortgage loan proceeds typically do not affect your Social Security or Medicare benefits, though they may affect eligibility for other federal assistance programs such as Medicaid. To confirm how a reverse mortgage might impact your tax situation and program eligibility it is best to consult with a financial adviser or certified public accountant.
Although reverse mortgage proceeds are not taxable, there are circumstances where you might be able to deduct the interest paid on the loan from your income taxes.
Similar to the mortgage interest deduction that allows traditional mortgage borrowers to itemize the amount of interest paid on their loan for their income taxes, a reverse mortgage also allows borrowers to receive a tax deduction.
On a regular, “forward” mortgage, the Mortgage Interest Deduction allows homeowners to reduce their taxable income by the amount of interest paid on the loan that is secured by their principal residence.
A borrower who refinances a standard mortgage with a reverse mortgage will lose the annual mortgage interest deduction if they don’t make payments, but will be able to deduct interest if they do make payments. If they make payments toward the loan balance, they may also be able to deduct mortgage insurance premiums this year, for adjusted gross income up to $109,000 if married filing jointly.
With reverse mortgages, interest accrues over the life of the loan either at a fixed rate or adjustable rate, whichever option the borrower has chosen. So while you are not paying down the loan balance, as you would for a regular mortgage, the reverse mortgage loan balance actually increases over the life of the loan.
“…the accrued interest on a reverse mortgage is not deductible on income tax returns until the loan is paid off.”
In the case of reverse mortgages, however, it is important to note that the accrued interest on a reverse mortgage is not deductible on income tax returns until the loan is paid off.
Additionally, a borrower with no existing mortgage will have no interest deduction to lose, but a borrower who refinances a standard mortgage with a reverse mortgage will lose the annual Mortgage Interest Deduction, according to the Journal of Accountancy.
Another way to think about the tax implications of reverse mortgages is to consider how using a HECM may impact withdrawals from investment accounts such as 401(k) plans and IRAs.
Employer-sponsored 401(k) plans and Individual Retirement Accounts (IRAs) are two common investment vehicles for many retirees. While both of these financial instruments allow investors to sock away funds for their retirement, withdrawals are taxed as regular income.
There is also a penalty if you withdraw funds from these accounts earlier than certain age thresholds. For 401(k)s, if you were to withdraw funds before reaching age 59.5, not only will you owe income tax on the amount withdrawn, but those funds would also be subject to an additional early distribution tax. For Roth IRAs only, withdrawals are tax-free as long as you are 59.5 or older and your account is at least five years old.
A reverse mortgage, if used as a line of credit, can help retirees avoid taking early withdrawals from these valuable retirement accounts.
Retirees could also use a reverse mortgage line of credit in its entirety during the first few years of retirement, enabling them to avoid taking substantial withdrawals from an investment portfolio in the early years, thus allowing it to grow, said Jamie Hopkins, associate professor of taxation at The American College in Bryn Mawr, Pennsylvania, and a frequent contributor to Forbes.
“It would also safeguard against taking needed withdrawals from the growth portion of their investments during periods when the market is in a decline,” Hopkins wrote in one Forbes article last year.
Another strategic use of a reverse mortgage, Hopkins noted, would be using the loan to postpone claiming Social Security benefits, though this strategy requires using more home equity early during retirement instead of later.
For example, consider a 62-year old retiree who is single, owns a $200,000 home with no remaining mortgage. In Hopkins’ example, he calls this retiree Joe.
Joe expects to receive roughly $1,000 per month from Social Security if he begins collecting benefits at age 62. If Joe wanted to delay benefits even further to age 70, when they will be substantially greater than at age 62, he could consider a reverse mortgage, from which he would be able to access roughly $97,000 of his home equity.
In order to generate a credit line withdrawal to receive monthly $1,000 payments for the next eight years—to replace the Social Security income that is in deferral—Hopkins notes that Joe would need to use up about $75,000 of his home equity.
Doing the math ($97,000 — $75,000), this means the line of credit would still have roughly $22,000 remaining, which could then be put toward other uses and daily living expenses. Meanwhile, the Joe’s home would still have more than half of its equity left.
“This would enable Joe to defer his Social Security income to age 70 and receive roughly 78% higher benefits (roughly $1,780 a month), based on an average increase of 7% to 8% per year,” Hopkins writes. “This strategy could also be employed for anyone who wants to defer taking withdrawals from their 401(k), IRA, or pension plan.”
Because everyone’s tax situation is different depending on individual circumstances, Gruley says it is important to consult with a financial adviser or certified public accountant to help determine if you could use a reverse mortgage to increase the cash available to you during your retirement.
