Add the IRS to the latest organization that has muddied the reverse mortgage “waters.” Many times the IRS is unreasonably, unjustifiably, and unfairly blamed for tax provisions it must enforce even though Congress and in most cases the President created them — whether the IRS supported their creation or not. This is NOT one of those cases.

In updating the latest edition of IRS Publication 554, “Tax Guide for Seniors”, someone within the IRS decided to add one paragraph on Page 17 summarizing some of the tax rules related to reverse mortgages. Although it appears that the underlying intent was to help seniors, it does just the opposite.

The following sentence is the clearest example of the incorrect information contained in the Reverse Mortgage paragraph in the 2008 edition of IRS Publication 554:

Any interest (including original issue discount) accrued on a reverse mortgage is not deductible until the loan is paid in full.(Bold italics added.)

This is utter nonsense. Unfortunately like all other IRS Publications, the legal documents and reasoning behind the stated positions are not included in Publication 554.

Fortunately in 1980, the IRS issued Revenue Ruling 80-248, a well written, reasoned, and documented position on two issues affecting reverse mortgages, one related to lenders and the other, borrowers. The Revenue Ruling starts off by asking:

Q. “When is interest on a ‘reverse mortgage loan’ … deductible by a borrower …?”

And then after analyzing the applicable law and regulations, the Revenue Ruling holds:

A. “The interest is … deductible by the borrower when it is actually paid by the borrower.” (Bold italics added.)

In the hierarchy of federal income tax law, Revenue Rulings have a much higher position than IRS Publications. Generally (unless the conflicting information in the Revenue Ruling is outdated or revoked) this means that when a Revenue Ruling and an IRS Publication are in conflict, the Revenue Ruling will prevail. It seems the Publication 554 author either mistakenly overlooked the Revenue Ruling or intentionally ignored it. IRS management needs to take a stronger hand in implementing a thorough review of the publications it releases to the public to avoid such glaring errors and erroneous guidance in the future.

For most borrowers, the date that any interest is paid on a reverse mortgage is the day it is paid off in full. For these seniors, the wrong information contained in the statement quoted from the 2008 IRS Publication 554 will have no impact. However, for those seniors who can utilize interest deductions before the loan is paid off and who implement proper tax planning strategies to avoid (not evade) or delay the incurrence of income tax liabilities, deducting interest in the tax year paid can be an important and useful income and estate tax planning tool.

The trouble with Publication 554 is that if a taxpayer pays some or most of the interest in tax years before the loan is paid off in full and follows the guidance contained in the publication by deducting all of the interest in the tax year when the loan is paid off in full, some or a very significant portion of the interest deduction could be disallowed since it should have been deducted in the tax years when the interest was paid. Further if the statute of limitations has expired for any of the prior tax years that the taxpayer should have deducted the interest, the income tax benefits from those interest deductions will be lost.

Since a reverse mortgage as to its fundamental legal and tax “core” is no different than any other mortgage, the logic in the 2008 Publication 554 could lead one to the conclusion that interest on a 30‑year forward mortgage cannot be deducted each tax year as the deductible home mortgage interest is paid but rather only in the tax year when the mortgage is paid in full. Imagine the reaction that conclusion would get from the public at large.

Almost all taxpayers are generally required to use the cash method of accounting in determining their itemized deductions such as state income taxes, property taxes, medical expenses, and home mortgage interest deductions. The banks and the IRS agree that taxpayers should deduct their home mortgage interest to the extent it is deductible in the tax year it is paid. That is why borrowers who have mortgages on their homes get Form 1098 annually showing the total interest they paid on their home mortgage during that tax year.

The problem with 2008 Publication 554 is that its interpretation of when reverse mortgage interest becomes deductible is not its sole or even its most glaring error. The addition of the Reverse Mortgage paragraph in Publication 554 with no circulation or review of its contents within the tax community before releasing it to the general public was an unfortunate mistake. Due to IRS and the Government Printing Office protocol, it is highly unlikely that this paragraph will be corrected even in reprints of the 2008 edition. The likely time of any change is the first printing of the 2009 edition of Publication 554 — at the earliest.

The IRS can do a much better job and should!!

James E. Veale, CPA, MBT
SVP of Tax and Government Affairs & Director of Originator Recruiting for Security One Lending

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Because facts and circumstances can vary between taxpayers, the advice rendered in this article was not written for the purpose and cannot be relied upon to avoid or mitigate any tax penalties. As in all tax matters, taxpayers should seek the advice of a qualified tax professional who is knowledgeable, experienced, and competent to advise on such matters.