Is a Reverse Mortgage Taxable?
Reverse mortgages are loans that help seniors convert home equity into income during their retirement years. One reason for their appeal? Reverse mortgages are repaid only when borrowers move out of the house, sell or die. That’s also what makes them complicated financial products.
The complications compound when you consider the long-term tax implications of borrowing on a reverse mortgage. Proceeds from a reverse mortgage aren’t taxable, but there are tax implications for a borrower’s heirs. Ignoring them in the short term could lead to headaches and lost money down the line.
In this article, we’ll walk you through the ins and outs of using a reverse mortgage and how to plan for the future.
- Reverse mortgage tax basics
- Capital gains taxes and reverse mortgages
- Reverse mortgages and tax deductions
- Special cautions related to reverse mortgages
- Is a reverse mortgage right for your retirement?
Reverse mortgage tax basics
Most reverse mortgages are Federal Housing Administration-guaranteed home mortgages loans available to adults 62 and older. Seniors who take out a reverse mortgage can use it in several ways:
- To purchase a home or pay off an existing mortgage
- As a line of credit, borrowing money as needed until the loan limit is reached
- To receive “term” payments of equal monthly amounts
The “income” seniors receive from a reverse mortgage isn’t taxable. A reverse mortgage is a loan with an expectation of repayment. No matter how you use proceeds from a reverse mortgage, you won’t pay income tax on the loan proceeds.
Although seniors don’t have to pay taxes on their reverse mortgages each year, using a reverse mortgage could have massive tax implications later on, when they move out of the house or when the home passes into their estate. James E. Veale, a certified public accountant who has studied the tax implications of reverse mortgages, told LendingTree, “When it comes to understanding the taxation of reverse mortgages, most people don’t understand what they’re getting involved in.”
Capital gains taxes and reverse mortgages
One of the most important tax areas for reverse mortgage borrowers to consider has to do with capital gains taxes. Capital gains taxes are the taxes that you may have to pay when selling an asset such as your home.
Capital gains when selling an inherited home with a reverse mortgage
When a reverse mortgage borrower dies, the house guaranteeing the mortgage passes into the borrower’s estate. When this happens, the heir receives a “step-up in basis.” In the eyes of the IRS, the value of the property is the fair market value of the property on the day your heirs inherit it. As a result, heirs don’t incur capital gains or have to pay capital gains taxes when they sell the property right away. If an heir holds onto the property, their capital gains tax burden will be based off the value of the property when they inherited it, not when you bought it.
Capital gains when selling a home
Seniors who plan to sell their home before it passes into their estate may more acutely feel the consequences of capital gains taxes. When you sell a primary house, you don’t have to pay capital gains taxes on the first $250,000 ($500,000 for a couple filing jointly) in asset appreciation. If you paid $100,00 for your home in 1992, and you sell it for $300,000 today, the entire $200,000 gain is tax-free.
On the other hand, if you paid $250,000 for a house in 2000, and the house is now worth $600,000, you have $350,000 worth of gains in the house. You’ll have to pay capital gains tax on $100,000 worth of gains when you sell the house.
If you’ve lived in a house a long time, or the area where you live has experienced rapid increases in housing prices, you may want to consult an accountant before selling your house.
Special situation: Loan is worth more than the house
The capital gains taxation rules apply whether you have a reverse mortgage or not. But if you sell your house, and the reverse mortgage is worth more than the value you receive for the sale of your home, the remainder of the loan is forgiven. The amount of the loan forgiven counts as additional proceeds in the sale of your home.
The forgiven amount counts against your home equity exclusion. In rare cases, this could mean that you have to pay capital gains taxes on some of the forgiven loan.
Example: If you bought a house for $400,000 in 1989, and you sell it for $700,000 today, you have $300,000 worth of capital gains. Now add to that situation a reverse mortgage where you owed $750,000. Upon the sale of your home, you would have $50,000 of the reverse mortgage forgiven. Besides the $300,000 gains from home appreciation, you have $50,000 in “gains” from loan forgiveness for a total of $350,000 in capital gains. Since $250,000 is excluded, you will owe capital gains taxes on $100,000. You owe the capital gains to the IRS, even though you walk away from the sale of the home with no money in your pocket.
Reverse mortgages and tax deductions
While seniors have to understand capital gains tax rules, they also have to understand that reverse mortgages present a unique opportunity for a tax deduction.
Since a reverse mortgage is a home mortgage, the interest that accrues on the debt could be deductible the year that a borrower or their heirs pay the interest. Unfortunately, since the 2017 passage of the Tax Cuts and Jobs Act, the deductibility of interest isn’t always easy to figure out.
John Ross, an elder law attorney and co-host of the Big Picture Retirement podcast, explained: “Now that the Tax Cuts and Jobs Act is in effect, home equity interest is no longer deductible. You can only deduct interest on debt that is used to buy a house, or to remodel or substantially improve your house.”
Example: A couple uses a reverse mortgage to purchase a new, downsized home for retirement, and they use the funds for no other purpose. In this case, the interest on the mortgage is deductible when the interest is paid. That means if the reverse mortgage has accrued $250,000 worth of interest charges over the last 30 years, and then the couple dies and you inherit the house, all $250,000 is deductible in the year you inherit the house.
Keep in mind the deductibility of the interest is limited to the first $750,000 of mortgage debt. If the principal value of the reverse mortgage is more than $750,000, the additional interest isn’t deductible. It’s also important to note that any deductible interest must be deducted against income. Someone who inherits a legitimate $100,000 interest deduction has to earn at least $100,000 of income to take the full deduction.
Consulting an accountant can be particularly helpful because the IRS hasn’t clarified all the rules on the deductibility of interest on reverse mortgages. For example, Veale pointed out that the compounded interest (which is the interest charged on the accrued interest) is probably deductible, but the IRS hasn’t specifically addressed that question.
If the reverse mortgage was used for a home purchase, a mortgage repayment or a substantial home improvement, the interest is deductible at the time it is paid. But heirs have to prove that the interest is deductible. Often, this means that the heirs of retirees will need to dig up 30 or 40 years of records to claim the right amount. To make this easier, Veale recommends, “However you use the funds for a reverse mortgage, the senior should keep their children or heirs involved in the planning step.”
Keep good records. Those records will be critical for calculating what amount (if any) of the interest on the reverse mortgage is deductible. Veale advised: “There are two things that seniors need when taking out a reverse mortgage. First, they need a tax person that actually understands the rules. Second, they need to track how they use the proceeds and tell their heirs how they used it.”
Special cautions related to reverse mortgages
The tax implications of reverse mortgages are just one factor that seniors should consider when planning their retirement. Reverse mortgages can be heavily marketed products, but they aren’t the only way for seniors to find the funding they need for their retirement.
Ross explained that many retirees turn to reverse mortgages when they need to pay for home health care expenses. But he urges his clients to consider other sources of financing. He asks clients to consider: “Do you qualify for Medicaid or veterans’ benefits? In some cases, a HELOC (home equity line of credit) could be a better choice, even though you’ll have to make interest payments on the [loan].”
Is a reverse mortgage right for your retirement?
In the right situation, a reverse mortgage may make a lot of sense for you. But reverse mortgages are complicated financial products with far-reaching tax implications. Before you take out a reverse mortgage, consider working with a HUD counselor and an accountant that understand reverse mortgages. With insights from experts, you can make the best decision for yourself and your heirs.