For the last couple of weeks our Lakewood branch office manager has been responding to calls from clients, who acquired their HECM in 2008, about why they are receiving 2008 Form 1098.  Most are calling because the only box showing any amount is Box 4 (mortgage insurance premiums) and, of course, their real question is, can they deduct it and if so, how much?

No doubt, many of you have gotten similar calls.  Few callers will appreciate the right response:  “You may be able to deduct it.  The best person to answer your question is your personal income tax advisor.”  Many, perhaps most, respond:  “But I don’t have one.  That is why I am calling you.”  Resist the temptation of attempting to answer their question.  Many times they need professional tax advice anyway.

To interpret tax law is like analyzing “…a riddle wrapped in a mystery inside an enigma….”  Later in that same quoted sentence on the Soviet Union, Winston Churchill goes on to say: “…perhaps there is a key.”  Some keys to understanding Box 4 of 2008 Form 1098 are IRS Notice 2008-15 and 1986 Internal Revenue Code (IRC) Sections 163(h)(3)(E), 163(h)(4)(E), and 163(h)(4)(F) — updated for all amendments at least through  January 1, 2008.  (There was no version of the IRC easily available on the Internet at no cost to the user which has been updated for the most recent amendments to those sections.) A “fair” summary of the MIP deduction is found on Page 7 of IRS 2008 Publication 936.

Here are just some of the rules that apply to FHA MIP for HECMs:

1. The FHA insurance contract must have been issued after December 31, 2006 and before January 1, 2011.
2. Amounts paid or accrued must be allocable to the four year period beginning on January 1, 2007 and are only deductible to that extent in those four calendar years.
3. The deduction is limited to the portion of the debt used to acquire the residence, construct it, substantially improve it, and payoff a mortgage to the extent that the paid off mortgage qualified as Acquisition Indebtedness.  For example if the MIP allocable to 2008 is $1,600 and the ratio of the Acquisition Indebtedness to the total cumulative proceeds used is 40%, then the deduction will be limited to $640 (i.e., 40% X $1,600).
4. Generally the 2% FHA upfront MIP must be allocated for 84 months.
5. To the extent deductible, MIP is classified as interest expense and for most taxpayers, it is qualified residence interest.
6. Adjusted gross income limitation rules apply starting at $100,000 ($50,000 for married individuals filing separately); no deduction is available for those taxpayers with adjusted gross income exceeding $109,000 ($54,500 for married individuals filing separately).

It never fails that just when it looks like things are almost done, the IRS throws in a monkey wrench.  In the first year the IRS permits the lender to report the 0.5% MIP paid on the outstanding balance plus either:

1. the total 2% upfront MIP incurred during the year, or
2. the amount allocable to that year which is the product of multiplying the 2% upfront MIP times the ratio of the number months that the insurance was in effect in that year divided by 84 (the amortization period).

If the total 2% upfront MIP was reported in Box 4 as described in the first numbered point above, then the borrower must remember to do the amortization calculation each year thereafter.  Because of the potential confusion over the two possible ways to report the MIP information, the IRS advises borrowers to contact the lender to find out which method the lender used if they have any questions.

If the HECM proceeds have been used solely for food, clothes, cars, paying down credit cards, vacations, and similar items, none of the MIP is deductible since none of the proceeds qualify as Acquisition Indebtedness.  Acquisition Indebtedness must be determined each year.

If any of the HECM proceeds were used to pay off a mortgage, that mortgage must be analyzed to see the extent to which proceeds from that loan qualified as Acquisition Indebtedness.  Acquisition Indebtedness is the total proceeds used to acquire a home, construct it, or substantially improve it; however, the total Acquisition Indebtedness cannot exceed $1,000,000 of the total proceeds.  Tracing the use of these funds and leaving an audit trail is critical for proving to the IRS what proceeds qualified as Acquisition Indebtedness.

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 tax penalties.  As in all significant tax considerations, taxpayers should consult a qualified tax professional who is knowledgeable, experienced, and competent to advise on such matters.