IRS Corrects Reverse Mortgage Misinformation

February 4th, 2009 | by Jim Veale Published in Commentary, News, Reverse Mortgage | 17 Comments

Last Wednesday, I published IRS Misinformation on Reverse Mortgages in which one section of the IRS Tax Guide for Seniors, Publication 554, was reviewed. For the first time in that publication, the IRS added a paragraph on reverse mortgages (RMs). Several sentences in that paragraph needed correction.

One problem in particular really stood out, the question of when deductible interest on a RM can be deducted. In Revenue Ruling 80-248, the IRS had previously stated that interest can be deducted when paid, but in Publication 554, a different group in the IRS now claimed that none of the interest could be deducted until the RM is paid in full. Of course as most of us know, usually none of the interest on a RM is paid until the RM is paid in full.

The next morning (January 29, 2009) the IRS responded to an email I had sent them on December 18, 2008 about the apparent conflict between Revenue Ruling 80-248 and Publication 554. In their email they stated that Publication 554 is being revised to include the “when paid” standard of Revenue Ruling 80-248. This is a welcome result for those RM borrowers who do tax planning and pay down their RMs to take advantage of interest deductions (and in the process generally lower their overall net RM costs) before the mortgage becomes due and payable.

The unrevised Publication 554 is no longer available on the IRS website. Below is a redacted and edited copy of the January 29^th email from the IRS. The salutation and content, however, remain intact as does font color and style.

Dear Mr. Veale:

Thanks for your email regarding the material about reverse mortgages in our Publication 554. Because of your email, we are planning to revise that material as shown below (changes shown in red). We are planning to post the revised publication on www.irs.gov within the next few days.

Reverse Mortgages

A reverse mortgage is a loan where the lender pays you (in a lump sum, a monthly advance, a line of credit, or a combination of all three) while you continue to live in your home. With a reverse mortgage, you retain title to your home. Depending on the plan, your reverse mortgage becomes due with interest when you move, sell your home, reach the end of a pre-selected loan period, or die. Because reverse mortgages are considered loan advances and not income, the amount you receive is not taxable. Any interest (including original interest discount) accrued on a reverse mortgage is not deductible until you actually pay it, which is usually when you pay off the loan [deleted: is paid] in full. Your deduction may be limited because a reverse mortgage loan generally is subject to the limit on home equity debt discussed in Publication 936, Home Interest Mortgage Deduction.

You mentioned that there is at least one other statement that may need correction. If you could let me know this week what that statement is, we may be able to fix it as well.

Xxxx Xxxxx

Tax Law Specialist (Reviewer)

Tax Forms and Publications Division

As requested, in an email sent early Sunday morning (2/1/2009), several issues were presented to the IRS including some the Publication did not address:

Changing the sentence on the tax-free nature of RM proceeds so that it declares that reverse mortgage proceeds are generally not taxable at the time they are received.
Modifying the last sentence to add Acquisition Indebtedness and Personal Indebtedness as other categories of interest that limit the deduction of qualified residence interest.
Correcting the name of IRS Publication 936 to Home Mortgage Interest Deduction.
Adding other items of concern: deductibility of 1) FHA MIP and 2) origination fees.

Because of the short time frame the IRS is up against, it is doubtful that the IRS will incorporate the additional suggestions other than the correction of typos and some simple editing. Taking everything into consideration, this has been one of the most pleasant and courteous experiences in a spirit of cooperation yet with the IRS.

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

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.

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http://www.ReverseWithLinda.com Linda Lewis

Hello – this is very interesting because on 11/14/08 a prospective client asked me if interest payments on a Reverse Mortgage were deductible. Our BofA account manager told me: “you can pay down the principal, but you can’t actually pay down the interest on a Reverse Mortgage.”
http://www.reversemortgageconcepts.com/ Mike Manfredi

Your account manager is wrong. You can pay the entire debt, principle and interest, at any time.
James E. Veale, CPA, MBT

Ms. Lewis,

On Page 2, Item 6 of the current B of A HECM Adjustable Rate Note, there is an application order to any payment made by the borrower. The order is very significant and affects the amount allocated to accrued interest. All reverse mortgage notes should contain similar payment application rules.

Unfortunately the word “principal” is overused and overworked by lenders and thus can be very confusing when reading notes and other legal documents. Lenders call the entire balance due “principal.” However, Item 6 states that payments will be applied in the following order “to that portion of the principal balance representing”:

• FHA MIP,
• next servicing fees,
• then accrued interest, and
• finally the remainder of the balance due.

Like all lenders, B of A issues IRS Form 1098 annually. It is commonly referred to as the end of the year mortgage interest statement. The amount declared in Box 1 of that form as interest received by the lender, reflects the application method prescribed by the note to the payments received from the borrower. That form should declare accurate on how payments received from the borrower during that calendar year were applied to accrued interest; however, that form does NOT reflect how much of that interest is actually deductible. Although very technical, IRS 2008 Publication 936 will help in that regard.
James E. Veale, CPA, MBT

Everyone,

I apologize for the loss in color that took place when the redacted and edited email was downloaded unto this website. This is the first time I have seen it.

Everything from “Dear” through the end of the first full paragraph along with the final paragraph was in blue. The entire middle paragraph was in black except the words in the following phrase which was in red: “…you actually pay it, which is usually when you pay off…”

Again this means interest is deductible in the tax year paid which is no different than the rules for traditional 30-year forward mortgages.
Denine Sadlowski

Mike Manfredi is correct! A senior can opt to make a payment anytime. It will first hit the MIP Premium, Service Fees, Intrest and then Principle.
Jim Stengel

The issue really is: how will partial pre-payments of a reverse mortgage be applied by the lender. I have been told that a lender will allocate all of the payment to interest only if the borrower so directs by writing on their payment check “to be applied to interest only”. Otherwise, the lender issued IRS Form 1098 will not reflect this and the deduction will be disallowed. Is the lenders allocation of pre-payments mandated or only applied in the absence of direction from the borrower?
Michael

This really should not be that complicated. If your paying down some of the interest to “preserve” more equity in the home, this amount should be tax-deductable.

When the property sells, anything above and beyond the original principal is obviously interest and can be deducted at that time.

Again, most seniors are not going to “pay down” the reverse mortgage interest as they usually need the money for other things. Therefore, once sold, a nice size deduction would be applied to any income earned in that year.
Brenda Wheeler

Thanks for the good information. While I make it a practice to refer customers to their tax advisor, it’s nice to have something “official” to tell them. May I get a copy of this emailed to me so I can print it out in a nice copy?
James E. Veale, CPA, MBT

Ms. Wheeler,

Due to the specific IRS personnel information provided in that email, I am unaable to provide an unredacted copy of the email to anyone other than Admin. and senior management of NRMLA and Security One Lending, Inc. (which all three groups have). If not already posted, the revised version of Publication 554 should be available at the IRS website shortly.
http://www.ReverseWithLinda.com Linda Lewis

Hello again – Thank you all for this great information. To further clarify:

Let’s assume my 65-year-old client makes monthly payments to cover the MIP, service fees, and interest on a Reverse Mortgage. [Whether this makes sense is another whole discussion]. Can he deduct the interest?

It sounds like we have to wait for IRS 2008 Publication 936. However, there is still no asurance that the lender’s 1098 will reflect that all of the interest paid is deductible. Right?
James E. Veale, CPA, MBT

Mr. Stengel,

This is a somewhat rare practice in the forward industry when the borrower is trying to catch up on mortgage payments. If audited, the IRS could reject the application of the payment to interest as requested by the borrower if that application was in conflict with the note.

As to proprietary RMs and HomeKeepers, writing the information as you state may work but I would certainly review the “prepayment” application section of the note. If the senior is expecting the interest to be equal to the payment amount, the senior may want to get the specific mailing address of the service provider employee that is stating the procedure (when in contradiction to the note) so that that employee gets the check and can apply the payment as requested.

As to HECMs, service providers generally follow the application order in the note despite what the borrower requests. Maybe you can find a HECM service provider employee who will apply the payment as requested, I have not.
James E. Veale, CPA, MBT

Michael,

There are many situations where debt negatively amortizes just as with reverse mortgages. Interest pay downs are not normally for the purpose of paying down the debt; that can be achieved through paying down the principal just as well. Usually the motivation behind an interest pay down is an income tax deduction.

Not everything above the original principal amount is interest. In most reverse mortgages (HECMs) “beyond” the original principal there are: 1) interest, 2) servicing fees, 3) FHA MIP, and 4) additional principal payments.

As to what interest meets the definition of “qualified residence interest” as presented in Internal Revenue Code Section 163(h)(3), IRS 2008 Publication 936 is very helpful. For example, if a senior took a lump sum of $200,000 and used it to buy a boat and a car and provide gifts for grandchildren’s eductions, only one-half of the interest would be deductible for regular income tax purposes and none would be deductible for AMT purposes.

The law changed in 1986 greatly limiting the interest deduction for many borrowers but reverse mortgage borrwers may find their deductions particularly limited.

My question to you, is a net pay down requested to get an interest deduction? The answer is no in two specific cases: 1) is by using all (or a portioon) of the remaining reverse mortgage itself to “pay down” the debt and 2) the other applies to some special cases under an election available under IRC Regulation Section 1.163-10T(o)(5).

Here is an example of just waiting may not result in the best tax result: Yesterday a frantic accountant called saying her client just received a 2008 Form 1098 with interest paid of $77,000. Her income for the year was $25,000. If the deduction had come in 2009, her income would have been about $100,000. So what is the better year to get the deduction, 2008 or 2009? Apparently, the senior refinanced in 2008 without the accountants knowing. The accountants were very disappointed; they had hoped that they could have paid down the accrued interest in 2009 so that the larger income could be more offset by more deductions and now so much of the 2008 interest deduction would not be wasted. Passive tax planning will not alwasys result in the best tax benefits to the borrower.
James E. Veale, CPA, MBT

Ms. Lewis,

Yes, the taxpayer (or tax preparer) will have to analyze the proceeds to see to what extent the debt can qualify as Acquisition Indebtedness and Home Equity Indebtedness. Many times after all of the work involved, the total itemized deductions is less than the standard deduction that is allowed anyway, so that the standard deduction is deducted rather than the itemized deductions for that year. This is why bunching is a great technique to use in maximizing itemized deductions especially if income goes up and down each year and bunching can be achieved that matches the highest income years against the years when bunching provides greater deductions than the standard deduction.
Sue Milligan

As far as tax-deductible interest goes, when a reverse mortgages is re-financed, (change in lending limits)
all the accumulated interest is now paid in full with the pay-off, or at the closing.
I’m not a CPA, but wouldn’t this qualify???
If so, wouldn’t this be a tool for someone whom had to start withdrawing from a retirement account at the age of 70 1/2?
They could take out a reverse mortgage at 65, refinance it in 5 years and not have an increased tax bracket due to the interest deduction.
James E. Veale, CPA, MBT

Ms. Milligan,

First let’s tackle your questions in three parts: 1) the timing of the tax deductible portion of the interest paid, 2) an overview of what is the tax deductible portion of the interest paid, and 3) economic benefit/detriment due to refinances (and even excess tax planning).

As you are well aware, the payoff of a HECM occurs when a refinance takes place as a result of a higher principal limit resulting from a significant increase in the appraised value of the home and/or an increase in the Lending Limit or the borrower switching from an adjustable rate HECM to a fixed rate. We may someday in the near future see some refinancing for the sake of getting a lower margin rate or with fixed rate a possible but unlikely lower fixed rate. Although not a refinance, we are now seeing some existing HECM borrowers moving to a new home using a HECM for purchase. Of course if they choose to retain the prior home, they will need to pay off the existing HECM.

For IRS purposes what appears to be indistinguishable from the perspective of a service provider, may or may not qualify as a refinance resulting in a payment of interest for income tax purposes despite the issuance of a Form 1098 with the amount of the accrued interest as of the date of refinance clearly displayed in Box 1. One key issue is who is the actual owner of the existing mortgage at the time of refinance. For example, let’s say that in 2007 Financial Freedom was still holding onto one of its Cash Accounts that it had originated in 2005. In 2007 the borrower refinanced to take advantage of the reduction in the margin from 5% to 3.5% and nothing more. Would that qualify for tax purposes as a refinance? We would need a lot more information in order to determine if this was truly a refinance for IRS purposes. But if the Cash Account had been sold in 2006 into the secondary market with Financial Freedom neither retaining nor obtaining any subsequent interest in that mortgage as of the date of the refinance, the transaction would qualify as a refinance for IRS purposes.

So most refinancing will qualify as a pay off of the accrued interest, especially if the refinance is with a different lender (although almost all refinances should qualify with the same lender). Now the senior should verify if he/she received a Form 1098 and the amount in Box 1 is correct. Of course there may also be amounts in Boxes 2 and 4 but if there are none, the senior should find out why. Generally Box 4 will only apply to HECMs originated after 2006.

Now we know the amount of interest paid in the calendar year but how much of that is actually deductible? Here the rules become more difficult. Interest must be divided into several categories. For most RM borrowers there are only three: Acquisition Indebtedness, Home Equity Indebtedness, and Personal Indebtedness. For more sophisticated taxpayers who use their proceeds for business, investment, or other allowable categories, and make a required election, even more categories of interest can be available but neither Acquisition Indebtedness nor Home Equity Indebtedness would be among them. How this works will be addressed in a subsequent article.

Now comes the test to determine if tax incentive refinancing makes sense. If based solely on income tax considerations, does the economic benefit of the tax deduction outweigh the additional costs of refinancing? The benefit side will produce a “cash like” increase immediately through a lower income tax liability or a greater refund and the detriment side will be an increase in a debt due to refinancing costs that will not paid off immediately or may not even be paid off during the senior’s lifetime but interest will be accuring on this increase.

If one is attempting to do tax planning and the required election was not made, one must then take into account the standard deduction. Since most RM borrowers do not need to file income tax returns, all of the tax planning in the world may just be for nothing except for fees to tax advisors; however, if their heirs have income tax liabilities, careful planning could be very worthwhile. For many seniors the Internal Revenue Code gives them more itemized deductions through the standard deduction than three or four times their annual increase in accrued interest could ever provide. Unfortunately many seniors believe they are getting tax benefits from their monthly mortgage payments when the facts are, the amounts of deductions produced do not match the standard deduction. While a strong believer in tax planning, it is also critical to weigh the costs incurred against the economic value and the potential economic value resulting from such planning.

But refinancing or paying off the entire RM may not be the only ways to get the interest deduction available treated as paid with no out-of-the-pocket cash expended to pay down the accrued interest. But that is a subject for a subsequent article.
Brad Lauritzen

My mother took out a Reverse Mortgage back in September of last year (2008). I was told by our loan officer at the time of closing on the Reverse Mortgage that the “Loan Origination Fees” are tax deductible. Is this true? I know that mortgage interest is not (until at which time the loan is converted back to a normal loan). But is tax deductible?
James E. Veale, CPA, MBT

Mr. Lauritzen,

When you want a reverse mortgage, go see a reverse mortgage originator. If you need tax advice, consult your tax advisor.

Did your loan officer tell you when the origination fees are deductible? I strongly suggest you obtain IRS 2008 Publication 936. Here are just of the questions you will need to address:

* Did your mother pay the origination fees out of
her own pocket or were they added to the loan
balance?

* What are the loan proceeds being used for?

* What percentage of the loan proceeds (not the
value of the home or the FHA lending limit) are
the origination fees?

If the origination fees are not deductible in 2008 in whole or in part, they may be amortizable and deductible over the life of the loan if that can be determined but only to the extent paid. If not, they may be deductible at the termination of the loan.

Remember not all of the origination fee may be deductible. This will require some analysis on your end.

Mortgage interest is never deductible by a cash basis taxpayer until it is paid; normally IRS Form 1098 is issued by the lender informing you about how much interest was paid. The amount paid is the starting point in determining how much of that amount may be deductible. Payment can also come about as a result of a refinance with a different lender.

The home mortgage interest deduction is limited by what category of home mortgage interest it falls into – acquisition indebtedness, home equity indebtedness, and personal indebtedness. While interest on acquistion indebtedness is deductible for all tax purposes, interest on home equity indebtedness is not deductible for alternative minimum tax purposes and personal interest is not deductible for any purpose. Other categories may also apply but not generally.

Finally don’t forget about the possible deductibility of FHA MIP if your mother has a HECM. The rules are somewhat tedious.

Again IRS 2008 Publication 936 will help you make the determinations required. You can obtain the publication on the IRS website. Good luck, and again you may need the help of a professional tax preparer who is competent, experienced, and knowledgeable about the tax issues related to reverse mortgages.