While real estate remains> in the doldrums, many older individuals own homes that are still worth plenty. Some of these folks may be house rich but cash poor. Taking out a reverse mortgage could solve that problem, but what are the tax implications? Good question. Before answering, let s cover the basics on how reverse mortgages work.
When you take out a regular home loan, you have to make monthly principal and interest payments to the lender. With a reverse mortgage, the lender makes one or more payments to you, the borrower. No payments to the lender are required until a triggering event occurs -- such as when the homeowner dies or moves out. Meanwhile, the accrued interest builds up, and the loan balance gets larger rather than smaller. That s why it s called a reverse mortgage!
Taking out a reverse mortgage can give an older homeowner access to needed cash without selling the property. In fact, many older homeowners may not qualify for a conventional forward home equity mortgage or line of credit because they lack the requisite income. For them, a reverse mortgage may be the only way to convert home equity into cash without selling.
You can receive reverse mortgage proceeds as a lump sum, in installments over a period of months or years, or as line-of-credit withdrawals when you need cash.
These days, most reverse mortgages are home equity conversion mortgages, or HECMs, which are insured by the federal government. You must be at least 62 years old to qualify. For 2010, the absolute maximum amount that can be borrowed under an HECM is $625,500. However, the actual lending limit depends on the value of your home, your age, and the amount of any other mortgage debt against the property. To give you an idea, a 65-year-old can usually borrow about 25% of his or her home equity. The percentage rises to about 40% if you re 75 and to about 60% if you re 85.
Interest rates can be fixed or variable depending on the deal you sign up for. Based on the information I ve seen, rates are somewhat higher than for regular home loans, but not a lot higher.
As I said earlier, a reverse mortgage doesn t require any payments to the lender until the borrower moves out of the mortgaged property or dies. At that time, the property is usually sold, and the reverse mortgage balance is paid off out of the sales proceeds. Any remaining proceeds go to the homeowner or his or her estate.
Fees Are High
Fees to take out and maintain a reverse mortgage will usually be considerably higher than for a regular forward home equity loan or line of credit. With an HECM, you ll pay an origination fee equal to 2% of the first $200,000 of the maximum claim amount (a figure that depends on the FHA loan limit for your area and your home s value) plus 1% of any maximum claim amount above $200,000. However, the origination fee cannot exceed $6,000. You ll also be charged a first-year FHA mortgage insurance premium (MIP) equal to 2% of the maximum claim amount. In later years, the annual MIP will equal 0.5% of the loan balance. In addition, the lender can charge a monthly servicing fee of $30-35. Typically, you ll also get socked with the familiar home mortgage closing costs for things like title insurance, an appraisal, settlement services, and so forth. All these amounts are tacked onto the reverse mortgage balance, and they can add up to big bucks.
Fees for lenders proprietary reverse mortgage products (a small percentage of the market) may vary widely from the above.
The first major tax issue is when and if you can deduct the reverse mortgage interest. The first $100,000 of the loan balance will usually qualify as home equity debt under our beloved Internal Revenue Code, and you can generally claim an itemized deduction for the interest up to that amount. However, no write-off is allowed under the alternative minimum tax rules unless you spend the loan proceeds on improving your home. In any case, you can t deduct any interest until it s actually paid in cash (as opposed to just being added to the loan balance). You may be in a far better place by the time your reverse mortgage and all the accumulated interest gets paid off, so I would not give much weight to the interest deduction.
The second major tax issue is relevant if selling your home would result in a gain that dwarfs what you could exclude under the tax rules ($250,000 for singles, $500,000 for married joint-filing couples). If taking out a reverse mortgage allows you to hang onto your valuable property until either you or your spouse dies, your heirs might be entitled to a big tax basis step-up that could reduce or eliminate any taxable gain when the property is finally sold. In some cases, the tax savings could be far higher than all the costs associated with the reverse mortgage. Talk to your tax pro if you think this consideration applies to you.