Reverse mortgage scenarios explored

Q Suppose a person has a reverse mortgage on a home that has greatly appreciated. What are the tax consequences when that person moves or dies?

L.D., Bothell

AA reverse mortgage is a special loan program that allows older homeowners to pull cash out of their home without making payments.

As its name implies, a reverse mortgage is the opposite of a regular mortgage. Instead of borrowing a sum of money and paying it back over time to reduce the debt, with a reverse mortgage a sum of money is given to the borrower but no payments are made and the debt grows larger each year. The equity can be pulled out of the home either in one lump sum or paid out gradually in monthly payments for life. The unpaid interest is added to the loan balance each month. The total loan balance, with accumulated interest, is eventually paid off when the home is sold, typically after the owner’s death.

To make sure the homeowners don’t outlive their equity, the loan-to-value ratio on reverse mortgages is kept very low at the start. Homeowners are allowed to borrow approximately 30 percent to 45 percent of their home’s appraised value, depending on their age. To qualify for a reverse mortgage the borrower must be at least 62 years old, and the older the borrower, the larger the allowable loan amount because their expected life span will be shorter.

Loan proceeds are not taxable income because the money must be repaid.

As I said above, reverse mortgages are typically repaid by the sale of the home after the owner dies.

But if the borrower chose to sell their home after taking out a reverse mortgage, they would pay off the outstanding balance on the reverse mortgage and keep the rest of the money. As long as the net profit from the home sale, after paying off the reverse mortgage and all selling expenses, was $250,000 or less ($500,000 for a married couple), all of the sale profits could be kept tax-free.

If the homeowner dies, the heirs inherit the house at a stepped-up cost basis, which means the Internal Revenue Service treats it as if they acquired the house at its current market value.

For example, if the home was worth $500,000 when the owners died, the heirs would inherit the property at a cost basis of $500,000. They could sell the home for $500,000, pay off the balance on the reverse mortgage and keep the rest of the money tax-free because they would have no gain on the sale.

Another unique tax consequence of reverse mortgages is the accrual of the mortgage interest deduction.

With a regular mortgage, the interest paid each year is tax deductible and you subtract it from your income on your annual tax return. But what happens when you don’t pay your mortgage interest each year, as is the case with a reverse mortgage? You don’t lose the interest deduction, you merely have to wait until the interest is actually paid before you can claim it.

For example, if a homeowner had accumulated $50,000 worth of unpaid interest on a reverse mortgage and decided to sell their house, he or she could claim a $50,000 mortgage interest deduction for the tax year in which the home sale closed.

Financial planners sometimes use reverse mortgages to reduce the estate tax burden on their clients. Also, even though no payments are required on a reverse mortgage, financial planners sometimes have their clients pay down some or all of the accumulated interest in tax years when it is advantageous for them to do so.

High net worth homeowners can use a reverse mortgage to buy a single payment “last-to-die” insurance policy that would pay off their reverse mortgage upon their death. The extra money from the reverse mortgage is given to their children. When the estate is settled, the tax-free insurance proceeds pay off the reverse mortgage principal, and the accrued mortgage interest deduction is used to offset the estate taxes. By doing this, money in the estate is moved from the taxable pile to the nontaxable pile.

This plan won’t work for everyone, so consult a tax adviser before attempting to use a reverse mortgage for estate planning purposes.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206. Fax questions to Tytler at 425-339-3435 or e-mail him at economy@heraldnet.com.