If you’re considering a reverse mortgage, you may be wondering about the tax implications of a reverse mortgage and whether the money you receive is taxable. Reverse mortgages allow senior homeowners to convert their home’s equity into cash during their retirement years, using it to provide additional income, fund home repairs and maintenance or cover other expenses.
One reason for their appeal? They offer additional cash flow like a home equity loan but don’t have to be repaid until the borrower dies, sells the home or moves out. Yet that’s also what makes them a complicated financial product to manage during tax season.
5 tax implications of a reverse mortgage
The good news is that the money you receive from a reverse mortgage isn’t considered taxable income. But that doesn’t mean there aren’t any tax implications for you as the borrower or your heirs. Below, we’ll walk you through the reverse mortgage pros and cons to help you plan for the future.
- Reverse mortgage income
- Social Security and Medicare eligibility
- Capital gains
- Mortgage interest payments
- Property taxes
1. Reverse mortgage income
The money you receive from a reverse mortgage isn’t taxable income. In the eyes of the IRS, the funds are considered loan proceeds rather than income. This tax treatment is similar to other funds that need to be repaid, such as a standard home equity loan or line of credit, or a personal loan.
2. Social Security and Medicare eligibility
Since reverse mortgage loan proceeds aren’t considered income, they won’t impact your Social Security retirement or Medicare benefits. However, they can impact need-based benefits such as Supplemental Security Income (SSI) or Medicaid.
This isn’t an issue if you intend to use the reverse mortgage proceeds right away, according to the National Reverse Mortgage Lenders Association (NRMLA), which says, “funds that you retain count as an asset and could impact eligibility.”
For example, if you borrow $5,000 from a reverse mortgage for home repairs and spend it in the same month, your SSI won’t be affected. However, if you keep the money in your bank account, it counts as an asset, which could make you ineligible for need-based benefits.
3. Capital gains
One of the most important reverse mortgage tax consequences has to do with capital gains taxes. Capital gains taxes are the taxes you pay when you sell a capital asset, such as real estate, stocks or other investments. Typically, when you sell an investment, you pay taxes on the difference between the sales price and your basis (usually what you paid for it).
The IRS does allow a special exclusion when you sell your primary residence. As long as you’ve owned and used the home as your primary residence for at least two of the last five years, you can exclude up to $250,000 of capital gains ($500,000 for married couples filing jointly).
One of the disadvantages of reverse mortgages is that there can be complications if your mortgage balance is greater than the home’s sale price. In this case, the difference between the loan balance and the sale price is forgiven. The amount forgiven counts as additional proceeds in the sale of your home.
Say you bought your home for $400,000 in 1989 and sell it for $650,000 today. You would have $250,000 of capital gains, none of which would be taxable due to the capital gains home-sale exclusion.
But let’s say you took out a reverse mortgage on that same house and currently owe $700,000. Upon the sale of your home, you would have $50,000 of the reverse mortgage forgiven. Besides the $250,000 gain from home appreciation, you also have $50,000 in “gains” from loan forgiveness for a total of $300,000 in capital gains. Only $250,000 of that would be excluded, meaning you’ll owe capital gains taxes on the remaining $50,000, even though you walk away from the sale with no money in your pocket.
4. Mortgage interest payments
For some people, one of the benefits of homeownership is the tax write-off you get for interest paid on a traditional mortgage. But that’s not always the case with a reverse mortgage because you don’t make monthly mortgage payments, and the balance of your loan goes up each month as reverse mortgage costs are added to the principle. That means the interest on a reverse mortgage isn’t deductible until you actually pay it, which is usually when you pay the loan in full.
Even then, realizing a tax benefit from the deduction might be tough. That’s because the Tax Cuts and Jobs Act (TCJA) of 2017 changed the rules for deducting interest on a home equity loan. Currently, you can only deduct interest on debt that is used to buy, build or substantially improve the home. So if you take out a reverse mortgage to remodel your kitchen, you may be able to deduct the interest when you later sell the home and pay off the reverse mortgage. If you use the reverse mortgage proceeds to cover other living expenses; it’s not deductible.
A couple uses a reverse mortgage to purchase a new, downsized home for retirement, and they use the funds for no other purpose. Twenty years later, the reverse mortgage has accrued $250,000 worth of interest. They sell the home to move into an assisted living facility, paying off the reverse mortgage in full. At that point, all $250,000 of interest is deductible.
Also, keep in mind the IRS limits mortgage interest deductions to interest paid on up to $750,000 of mortgage debt. If the reverse mortgage’s principal balance is more than $750,000, your interest deduction will be limited.
5. Property taxes
You’re still responsible for paying property taxes while you have a reverse mortgage. In fact, one of the reverse mortgage requirements is that you pay your property taxes and homeowners insurance on time. Your reverse mortgage lender may:
- Allow you to make direct payments to the insurance company and tax authority
- Set aside some of your loan proceeds to help you make direct property tax and insurance payments
- Put some of your loan proceeds in a set-aside account and make property tax and insurance payments on your behalf
Whether you pay your property taxes directly or the lender handles them for you, you may be able to deduct them on your tax return. But once again, determining whether the deduction will benefit you is complicated.
First, you need to itemize deductions on Schedule A, meaning your total itemized deductions, including medical expenses, mortgage interest, state and local taxes, and charitable contributions, have to be greater than your available standard deduction. Since the TCJA increased the standard deduction for all filing statuses, only about 11% of taxpayers itemize deductions.
The TCJA also caps the amount of state and local taxes you can deduct to $10,000 ($5,000 if married filing separately). This includes property taxes, state and local income taxes, and sales tax (if your state doesn’t have an income tax).
FAQs: Understanding reverse mortgages
How is money received from a reverse mortgage taxed?
The money you get from a reverse mortgage is not taxable income. The IRS’s reverse mortgage rules consider the funds to be loan proceeds rather than income.
What happens if I want to sell my home, but it’s not worth as much as the reverse mortgage?
Selling a home with a reverse mortgage is simple if the home’s value is greater than the mortgage balance. Sell the house, pay off the reverse mortgage and pocket the difference. But if the value of your home has fallen below the amount you owe, the lender will accept 95% of the home’s appraised value, or the full loan balance, whichever is less.
You may need to conduct a short sale — selling your home for less than the balance owed — if you have to sell when your home is valued at less than what you owe. The problem is, any real estate agent you work with will have to get the lender’s permission to list the home for less than the mortgage balance, and the lender may require an appraisal before agreeing to the listing. This is one of the reverse mortgage pitfalls: Short-selling a home with a reverse mortgage is usually time-consuming and complicated.
Is interest on a reverse mortgage tax deductible?
You can only deduct interest on a reverse mortgage when it’s paid. Since most reverse mortgages aren’t paid until the home is sold or the borrower dies, you may never benefit from the tax deduction.
In addition, the interest has to meet the other rules for deducting home mortgage interest. Under the current tax law, home equity debt is only deductible if the loan proceeds were used to buy, build or substantially improve the home. If you used the loan proceeds for any other reason — such as paying living expenses — the interest is not deductible.