Reverse mortgages are popular for older people who want to tap into the equity in their homes. They can provide a convenient source of financing for seniors who are “home rich but cash poor.”
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 wouldn’t 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 higher than the closing costs for a conventional home mortgage.)
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. That’s one reason why a reverse mortgage might be a good alternative to selling to free up necessary cash, which could involve an unwanted relocation as well as an income tax bill if the home has appreciated substantially in value.
But before signing on the dotted line, it’s important to understand the tax consequences.
Common question: Is reverse mortgage interest deductible on the homeowner’s federal tax return?
Answer: Probably not. Under current law, the interest on a home equity loan, which would include a reverse mortgage, is generally nondeductible for federal income tax purposes. (One exception is if the loan proceeds are used to acquire or improve the taxpayer’s first or second residence. Even then, the interest is only deductible as itemized qualified residence interest if the applicable mortgage debt limit isn’t exceeded.)
Before 2018, interest on the first $100,000 of reverse mortgage principal could usually be deducted under the rules for home equity loans at the time the interest was paid in cash. However, interest that was simply added to the loan balance wasn’t currently deductible.
To summarize, currently, it’s unlikely that interest on a reverse mortgage can be deducted on your federal income tax return.
Conclusion
Despite the currently unfavorable federal income tax treatment of reverse mortgage interest, a reverse mortgage can still make good financial sense in the right circumstances. Contact your tax advisor if you have questions or want more information.
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