Understanding Reverse Mortgages: Key Insights

Reverse mortgages provide a compelling financial tool for homeowners, especially those aged 62 and older, to harness their home equity for cash flow. Unlike traditional mortgages where payments are made to a lender, reverse mortgages allow the lender to pay the homeowner, whether as a lump sum, through regular disbursements, or accessible via a line of credit.

Securing a reverse mortgage requires a first trust deed, necessitating that any existing home loans be cleared with different funds or through the reverse mortgage proceeds. The loan amount is contingent on the borrower's age—the older the individual, the higher the potential loan amount and the lower the interest rate. Rules can be intricate, influenced by existing debts.

When settling a reverse mortgage, accumulated interest, along with the balance, must be paid. This interest, in certain instances, may be deductible. Below, we explore financial and tax considerations related to reverse mortgages:

Proceeds

Taxability: Monies received through a reverse mortgage, be it a lump sum, line of credit, or monthly payments, are treated as loan proceeds by the IRS, thus not taxable income.
Impact on Social Security and Medicare: Since these payments don't count as income, they won't influence Social Security or Medicare benefits determined by income levels.

Limited Interest Deduction

Interest Deduction Timing: Interest accrued on a reverse mortgage becomes deductible only upon full loan repayment, usually when the home is sold or upon the last borrower’s death.
Form 1098: This form is issued by lenders to report interest paid upon loan settlement.
Purpose of Loan Usage: Deductions generally apply if loan funds were used to "buy, build, or substantially improve" the home (IRC Section 163(h)(3)). For borrowers using funds for daily expenses, interest isn’t deductible even after repayment.
Determining Deductible Interest: Factors influencing the deductibility of accrued interest include loan characteristics and usage. Post-2017 limitations on equity debt interest mean that if a reverse mortgage replaces home acquisition debt, a portion of the interest is deductible when paid off.
Claiming Deductions: The repayment party can claim deductions, following specific criteria:
1. Borrower: If repaying while in residence, they claim the interest.
2. Estate: When the estate pays off, it claims deductions on its income tax return.
3. Heirs: They can claim deductible interest on personal returns if repaying the mortgage.

Deductibility Limitations

Cap on Loan Balances: Even when funds enhance the home, IRS limitations on home equity debt affect deduction eligibility, up to $750k post-2017 loans or $1M pre-2017.
Documentation Requirement: Retaining receipts and invoices is essential for justifying deductions when reverse mortgage funds are expended on home improvements.

Effect on Means-Tested Benefits

Risks for Medicaid and SSI: Reverse mortgage proceeds are counted as assets, potentially jeopardizing benefit eligibility if large cash sums are retained. It's vital to use received funds within the reception month.

Continued Borrower Obligations

Property Tax and Insurance: Borrowers must still handle property taxes, insurance, and upkeep costs. Defaulting here risks foreclosure.
Financial Examination: Prior to loan approval, lenders assess financial stability to ensure capability in managing ongoing expenses. Weak payment histories may trigger a Life Expectancy Set-Aside (LESA) allocation to cover these costs.

Heirs' Considerations

Limited Liability: Reassuringly, FHA-insured Home Equity Conversion Mortgages (HECMs) are "non-recourse," meaning heirs never repay more than the home’s value, even if loan totals eclipse sale proceeds, with disparities covered by FHA insurance.
The 95% Rule: To retain the home, heirs can acquire it for 95% of its appraised or the outstanding loan amount, whichever is lesser, thus safeguarding against debt exceeding home valuation.
Capital Gains Tax Application: For homes sold under a reverse mortgage, standard capital gains tax rules apply, allowing for a "stepped-up" basis for heirs, potentially reducing tax liabilities if sold shortly after inheritance.

Drawbacks of Reverse Mortgages

While reverse mortgages offer flexibility, they possess notable drawbacks. As interest mounts, loan balances inflate, reducing equity for both borrower and heirs. Furthermore, neglecting obligations like property taxes, insurance, or maintenance can lead to foreclosure.

Fee structures and closing costs may exceed those of traditional mortgages, possibly rendering them unsuitable for those contemplating near-term moves. Due consideration of pros and cons is recommended before proceeding.

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