Reverse mortgages – House Rich But Cash Poor?

Reverse mortgages are becoming increasing popular – especially for older people who want to tap the equity in their homes. They can provide a convenient source of financing for seniors who are “home rich but cash poor.”

Qualified individuals can keep control of their principal residences while converting some of the equity in the property into cash. Seniors often cannot qualify for conventional “forward” home equity mortgages due to low income, which is one reason why a reverse mortgage might be a good alternative.

But before signing on the dotted line, it’s important to understand the tax consequences.

Common question:

With a reverse mortgage, is the mortgage interest deductible on the homeowner’s federal tax return?

Answer: Yes and no.

The first $100,000 of reverse mortgage principal will most likely meet the tax-law definition of home equity debt. Therefore, the borrower can generally claim itemized deductions for interest on up to $100,000 worth of reverse mortgage loan principal.

(If the homeowner is subject to the alternative minimum tax, however, the write-off may be disallowed.)
Here’s the problem: The interest cannot be deducted until it’s actually paid in cash, as opposed to being added to the reverse mortgage loan principal. Because of the way most reverse mortgages work, payment in cash may not occur until long after the loan is taken out, assuming all the accrued interest is in fact tacked onto the loan principal. (See right-hand box to understand how reverse mortgages work.)

To summarize, no current federal income tax deduction is allowed for interest that is added to the reverse mortgage loan principal, since the homeowner is accruing – but not paying – mortgage interest at this point. If a current tax advantage is an important factor in the homeowner’s decision to obtain a reverse mortgage, this may not be the right choice.(IRS Revenue Ruling 80‑248.)

Even so, a reverse mortgage can make good financial sense in the right circumstances. Contact your tax adviser if you have questions or want more information.

How Reverse Mortgages Work

With a reverse mortgage, the borrower doesn’t make payments to a lender to pay down the mortgage principal over time. Instead, the reverse happens. The lender makes payments to the borrower and the mortgage loan principal gets bigger over time. However, the maximum initial loan principal amount is limited to a percentage of the appraised home value, which secures the mortgage. Typically, payments to the borrower are issued on an installment basis over a period of months or years.

Reverse mortgages usually allow interest to be added to the loan principal as it accrues, so the borrower doesn’t have to make principal or interest payments until otherwise required under the loan terms. Typically, payment isn’t due until the borrower dies or permanently moves out of the home. (“Permanently moves” is defined as not living in the home for 12 consecutive months. So an 11 month stay in a nursing facility after which the homeowner returns home would not qualify as a permanent move.) After a homeowner permanently moves, the property is sold and the reverse mortgage, including the accrued interest, is paid off out of the sales proceeds. Of course, if the property is sold earlier, the reverse mortgage must be paid off at that time.

As with any major borrowing transaction, it’s important to find a good interest rate and acceptable up-front charges. (The upfront charges of a reverse mortgage can be much higher than the closing costs for a conventional home mortgage.)

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