Are Reverse Mortgage Proceeds Really Income?

February 27th, 2009 | by Jim Veale Published in Commentary, News, Reverse Mortgage | 23 Comments

On February 12, 2009, two commentators on this website initiated a discussion of the appropriateness of using the word “income” to describe RM proceeds. Having waited for well over three months to opine on this issue, it seems now is the appropriate time to do so.

In November 2006, a well respected and long-time reverse mortgage originator addressed about two hundred originators in San Francisco on the subject of reverse mortgage terminology. When he referred to reverse mortgage proceeds as “income”, several hands in the audience shot up. Each had a question about how HECM proceeds were “income” in specific situations. It seemed like at the beginning of each response the speaker caveated with: “Well, they are not income in that sense.” Not once was there any clear explanation as to why they are income. By the end of the discussion, I wanted to jump up and shout: “Please explain in what sense reverse mortgage proceeds are income.”

Have you ever wondered why forward mortgage originators do not call the proceeds their loans provide, “income”? Not even HELOC proceeds are advertised or called “income”. So why do so many in our industry advertise reverse mortgage proceeds as “income”?

What is the primary difference between income and loan proceeds? Income does not have to be repaid unless it is 1) paid in error such as paid to the wrong person, 2) overpaid, 3) paid before it is due, 4) etc. Income includes salaries, commissions, wages, interest, dividends, royalties, rents, portions of annuity payments, sales, and fees. If you consider this discussion a matter of semantics then consider if you would trade your current compensation arrangement for one that pays the same amount of cash except that cash will have to be repaid to your employer with interest and “servicing fees” when you leave your employer or pass away? Does that seem like “income” to you?

Equity is the difference between the value of assets owned by an individual and liabilities owed by that same person. When income is received, it increases equity. For example, if you receive a check from IBM of $300 as an ordinary dividend and then subtract the increase in liabilities that payment caused (zero), the increase to equity will be exactly $300. The same is true with any other type of income; there is always some increase to equity. In fact in accounting theory, income is nothing more than a temporary classification and description of certain types of increases to equity.

But now let’s see what happens with a HECM tenure payment of $300. If we subtract the increase in debt that results from this payment ($300), the increase to equity is zero. So in what way are the payments to reverse mortgage borrowers anything like income? They are just like all other lender loan payments to borrowers, loan proceeds.

While it is clear that few marketers want to call them what they are, “proceeds”, that is no excuse for calling reverse mortgage proceeds anything else. Use of inaccurate and inappropriate words usually does not result in educating seniors but rather in confusing them.

Yes, the state of California requires reverse mortgage originators to provide seniors with a document that declares that reverse mortgages provide “additional income.” In running down why this wording was used with a California state Senator who sat on the committee that wrote the bill, he explained that some very well respected mortgage lender (who it turned out had never completed one reverse mortgage application) “helped” with the terminology in California Civil Code 1923.5. So in California we can legally use this ridiculous wording to describe reverse mortgage proceeds. Other states may not provide such protection against what some might construe as “false and misleading” advertising.

While reviewing this article for publication, John wrote that he was preparing a presentation using the website of a reverse mortgage lender as an example of a successful website when he came across the following: “There are 4 ways your additional income can be paid to you….” In what way is that “income” additional? Does a line of credit result from some type of income or income transaction? Is it really “paid to you?” Such language implies that a reverse mortgage line of credit belongs to the borrower and the heirs should have the legal right to inherit it upon the borrower’s death.

Some in our industry want to foster and increase professionalism and our professional image. One of the principal means of expressing our professionalism is in our marketing. If the words we use to describe our products are as poor and imprecise as calling loan proceeds “income”, we may never see a significant or serious rise in the perception of reverse mortgage originators as highly regarded professionals. Remember during the last Presidential election, one well respected Democratic leader called a Republican who had just committed what she considered dirty tricks against seniors — a “bogus reverse mortgage peddler.” What does that say about her opinion of reverse mortgage originators in general?

Can you imagine on a HECM for purchase how ridiculous it will sound if an originator says to a senior: “You have this much income to purchase that home”? A certain reverse mortgage software graph printout related to a HECM for purchase literally calls the available loan proceeds used to purchase the home “income received”. What forward lender calls the proceeds used to buy a home, income or “income received”?

In November, one of the speakers at the NRMLA Convention declared: “A reverse mortgage is an exchange of equity for streams of income.” This declaration makes little enough sense when the senior owns the home but makes even less sense in a purchase transaction.

A California judge was just recently convinced that he should be paid the growth from a line of credit since “that is nothing more than your income from not using that part of the loan”. When he found out those payouts increased the amount due, let’s just say I would not want to be that originator appearing before the court over which that judge resides.

Have you ever noticed the glazed eye look or glare that CPAs and attorneys have when you start describing the great income benefits of reverse mortgages? If we want the respect and support of those who advise seniors, we need to be accurate in what we call loan proceeds. Our industry should be maturing and a natural part of maturity is to drop the words and terms we used when we did not know better.

While it is not true that reverse mortgage tenure payments increase monthly income, it is true they increase monthly cash flow. It has been good to see that over time more and more reverse mortgage advertising has gone away from using the term “income” in describing proceeds to explaining the payouts as increases to monthly cash flow. Let’s hope with more time the term “income” will entirely disappear from use in our industry when describing loan proceeds.

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

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Andrew

Word!
http://home.earthlink.net/~bill_green/ William J. Green

Bravo! Long live, “Increases to cash flow.”
James A. Nelson

It’s truly sad that this Industry has done such a poor job of educating the general public, which includes
those who write laws, rules, or regulations, as to the
importance of FHA HECM loans (or private RM Jumbo loans again some day) for struggling, financially
stressed Seniors. Only true stories of Seniors saved
from the crush of overwhelming, home maintainence costs, credit card debt, medical and prescription drug bills, and simple living expenses will suffice. Easing the financial burden of Seniors in the last, perhaps very sickly, years by tapping some of their home equity with no monthly mortgage payment is a blessing of our economic capitalistic system. To ever call this source of funds income makes no sense to me. If anything (and I am not a CPA or a tax lawyer), the funds come from an asset whose value had increased over time; subject to whether the owner had previously tapped those funds thereby already using some of the gain, one would only encounter a capital gains tax (and never an income tax), subject to the value of the property and gain. In any case, for those Seniors who are fortunate enough to have home equity, the FHA HECM in my opinion is a Lifesaver: the real life human stories must be better publicized to inform skeptics in powerful places who could do this Industry great harm (and needy Seniors in the process).
Michael

So is it taxed as income or not? That should be a very simple question unless you are George Bush.
http://www.AmericanReverse.com W.L. Pulsipher

Congratulations James on correcting the misuse of the term “income” in describing the proceeds of a Reverse Mortgage. As you suggested, this error is widely used in our industry and shows how many of our “experts” are not so expert as they claim.
American Reverse Mortgage® (ARM) uses the term “cash” to describe “proceeds” although proceeds is probably a more descriptive term.

W.L. Pulsipher, CSA, ΔΣΠ
President
American Reverse Mortgage® (ARM)
352-867-1111
Bob LaFay

Proceeds from a Reverse Mortgage are similar to
withdrawals from an individula’s bank account. It does
nothing whatever to add to one’s net worth. A subject
worthy of discussion. Very well stated. Bob LaFay,Denver, Colrado
James E. Veale, CPA, MBT

Andrew,

I would love to understand what your response means. Please elaborate.
Louise

One of my potential borrowers read the Important Notice California lawmakers mandated with SB 1609 that lenders doing business in California must put in our loan packages, and when he read that equity was “a source of additional income,” he refused to do the loan even though his daughter was begging him to do so. He figured that if a reverse mortgage was called income, the state would figure out a way to tax him for that income. Hey, it is not income! It’s a loan and a very good loan for many people.
Vincent

James-

I thought I’d jump in to answer your question about “word” and hope Andrew doesn’t mind.

I am pasting in, with a smile, a quote from Matthew “Cado” Burr, drummer for Grace Potter & The Nocturnals on the Hollywood Records label.

But before I do, I want to add that “tax-free income” has been a real pet peeve of mine, and have always used “your funds” or “proceeds”

*Word is a phrase imported to my boarding school via Cameron Rappeler VanderVeer III. Word can mean various things in today’s society, but to my brotherhood of friends it was a sure way to find out if your best pals were telling the truth. For instance, if I walk into a room full of close friends and say “Hey Dan, I just heard a strange rumor that your girlfriend was seen making out with Joey at his party Saturday night.” Due to the powerful pact of word, Dan can find out if his friend is lying by saying, “Word?” If the receiver of word doesn’t say or clearly pronounce the word “WORD” then they’re lying. If they do say “WORD” then they’re telling the truth. That there my friends is a brief tutorial on the almighty Word. Feel free to give it a trial run anytime with your close circle of friends.”

PS. That’s Cameron’s real name…I’ve met him
Vincent

Word, without a question mark/ voice inflection is an affirmation that Andrew agrred with the article…
James E. Veale, CPA, MBT

Vincent,

Thank you.

And Andrew — Word.
James E. Veale, CPA, MBT

Michael,

I hate getting off track from the subject at hand, i.e., calling loan proceeds, “income;” however, I also feel as if your question needs to be addressed. I am not a tax attorney; however, I am a CPA with a graduate degree in taxation with over 37 years experience in tax matters. Since there are no facts or circumstances presented in your question, the following answer is a based on tax principles only. If more specific information is needed, the advice of a tax consultant with experience, knowledge, and competency in the field you are addressing should be sought.

As a practical matter, loan proceeds are rarely taxed at the time of receipt. Most of the time they are not and never will be taxable, especially if they are paid back in full by borrower or heirs.

There is also a theoretical issue over payments made by the lender to the borrower directly or to others on behalf of the borrower (such as FHA/MIP, the service provider, and if held in reserve the homeowner’s insurance company and county tax collector). If after making those payments the RM amount due exceeds the value of the home, there is some question if the lower of the payment or the amount by which the amount due exceeds the value of the home is not income at that time. This question applies only to non-recourse debt. Depending on the factual situation, such income may be eligible for exclusion but that topic is a whole separate article.

Gain on a non-recourse debt is an issue whenever there is a foreclosure. But again that topic exceeds the time and space available. Please do not forget, a trustee’s sale falls within the tax concept of foreclosure.
James E. Veale, CPA, MBT

Mr. Pulsipher,

You are correct. The asset the senior receives is cash and the payment increases the amount due. “Loan proceeds” is the description of the nature of what has been paid by the lender and received by the borrower directly or indirectly.
Abel Torres

No doubt a good explanation is given here. I would rather prefer to look at how the IRS treats Reverse Mortgages in general. According to an old Internal Revenue Service Ruling INTEREST; “REVERSE MORTGAGE LOAN”; WHEN DEDUCTED AND WHEN INCLUDED Published: September 15, 1980 26 CFR 1.451-2: Constructive receipt of income, the definition of when income is under “Constructive receipt of income” is at the crux of the question. As per the ruling I quote:

“Section 1.451-(a) of the Income Tax Regulations provides that income is includible in gross income for the taxable year in which it is actually or constructively received by the taxpayer, unless it is includible in adifferent year in accordance with the taxpayer’s method of accounting.
Section 1.451-2(a) of the regulations provides that income although not actually reduced to a taxpayer’s possession is constructively received by the taxpayer in the taxable year during which it is credited to the
taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time, or so that the taxpayer could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.”

Eventhough this ruling defined how interest paid on reverse mortgages is to be accounted, the IRS provides a glimpse of why the proceed of a reverse mortgage should not be considered income. It boils down to that as long as the money has “subtantial limitation or conditions” it cannot be considered income. Please note that ordinary income such as wages do not have such substantial limitations. Only after the loan is repaid, are these “substancial limitation or conditions” removed and then treatment of income or deduction for tax purposes can be considered.
Thank Jim for the good info on the Californial statute.
Let me know if you need a copy of the ruling.

Abel Torres
James E. Veale, CPA, MBT

Mr. Torres,

Thank you for commenting; however, I do not understand your point. This is not an article on income taxes.

On January 28, 2009, February 4, 2009, and then again on February 13, 2009, Reverse Mortgage Daily published three articles in which I cite Revenue Ruling 80-248. Unless I am mistaken, this is the ruling to which you allude. The ruling was used in those articles as the support why interest is deductible by a cash basis RM borrower when paid.

In the ruling the IRS also presents their rational as to when a cash basis lender must recognize the interest being accrued on a reverse mortgage as taxable income. Many cash basis lenders record interest income for book purposes as earned (accrual method) and recognize them for tax purposes when received (cash basis). The IRS did not address the issue of if the interest was taxable or even income to the lender in the ruling but rather when it is taxable. One of the tax principles used in 1980 to test when a cash basis taxpayer must recognize taxable income on cash received is the “substantial limitation or conditions.”

The purpose of the current article (published Friday, February 27th, 2009) was to discuss the inherent nature of loan proceeds in the hands of the borrower. This has nothing to do with its taxability or the IRS. The IRS makes no rulings or determinations in this regard at all. Their primary function is the collection of taxes as determined under the Internal Revenue Code. As the saying goes, “they have no dog in this fight.”

What the current article deals with is the economic, financial, accounting, and, yes, to a limited degree, the legal aspects of loan proceeds to the borrower. The income tax ramifications of loan proceeds to a borrower is an entirely different subject and one generally limited to the Internal Revenue Code, IRS documents, IRS publications, the judicial system, and authoritative treatises.

The relevant issue in the article is if by any standard (excluding income tax), loan proceeds paid directly or indirectly to a borrower are income to the borrower. It is my opinion and conclusion that those who advertise loan proceeds as “income” to the borrower (except in California) run the risk of being found as promoting false and misleading information. It is hoped that the California government will amend the “additional income” language found in its Civil Code.
eqqmc2

Mr. Veale,

I dont disagree with your original article and I understand the intentions. My point is that as you search for a clear answer to define whether loan proceeds in Reverse or Forward mortgages are considered as income, it is a prudent idea to look at rulings of institutions that look at the definition of terms such as income. If reverse mortgage proceeds were considered “income” by the IRS you could bet that we would have a very different discussion. There are other ramification of what loan proceeds are defined as, ie. resources, such as for Medicaid and State asistance programs. You also brough a good point about wealth transfer and the use of the term income and the associated consequences there. Now there is also the term “unearned” income, not just taxable or not-taxable income which is really what the IRS ruling was referring to. I usually find that there is a thread and logic in all the mess, if you trace it back to the legal avenue. That was my point. I totally agree with you about making sure folks in our industry do use the proper terms. On the other hand, saying that those who use the word income for loan proceeds are promoting false and misleading information, well that is an issue for the courts and you must have better grounds than just an opinion to win a lawsuit.
James E. Veale, CPA, MBT

Mr. Torres (I take it you are also eggmc2),

You certainly have the right to your opinion: however, I am compelled to point out certain information.

As to the need to look for sources to help one define what is income and what it is not, the IRS is at best biased. So are the Medicaid regulations as are the rules and regulations of most state assistance agencies. Better sources are theoretical books on economics, finance, and accounting by recognized authorities.

For example, the IRS imputes interest on interest free loans but only if they exceed certain amounts, are between specific parties, etc. The amounts and relationships selected were legislated by Congress for revenue purposes. Again the Internal Revenue Code requires the recognition of income when one switches from a taxable IRA to a Roth IRA.

The problem with the regulations you selected is that they have nothing to do with the issue of defining income but rather the correct time to recognize it. Constructive receipt is a long recognized principle of when a taxpayer must recognize most types of income for income tax (and only income tax) purposes.

As both a California CPA and a California real estate broker, there are many arenas other than a lawsuit where one can be “found as promoting false and misleading information.” There are government agencies, professional organizations, employers, the press, clients, and on and on it goes, not including one’s own conscience. Remember the NY AG found one RM lender to be employing deceptive marketing practices and settling the accusation with undisclosed fines and corrective measures by the lender without the lender ever stepping inside of a court room.

As to opining as to what constitutes income, qualified CPAs do that all of the time. If you want to view my grounds for opining, Admin will be posting my background in March.
Abel Torres (eqqmc2)

Mr. Veale,

I really dont want this interchange to go negative any further. As a former aerospace and telecom engineer and been in the end to end of reverse mortgage origination for a while I do certainly value the use of the textbooks in not just accounting, economics and accounting but also in physics, engineering and mathemetatics. The big difference in the former type of textbooks is that you and everyone else must follow the established laws and regulations devised by men, while the latter category you must proof your results thru valid scientific methods. Whether an institution like the IRS or Medicaid is “biased” or not that is a totally subjective opinion. My point has been that most of the time you can find some sense by following the thread of information given. You keep pointing back to the ruling saying that it has nothing to do with the subject discussed. If the proceed of the reverse mortgage were given without any substantial limitations or restrictions on the receipt of that money the IRS would consider those proceeds not only income but taxable income. Obviously that situation would equate to a gift which as you know is taxable after certain amount. I think the most important point here is how this definition of income affects the borrower, not just the definition of income. I certainly want to do the best for the borrower at all times. And yes I do go by eqqmc2 for a reason if you remember a little bit of physics LOL!!!
James A. Nelson

I’m just an ordinary , academically under educated,
average American. It’s obvious to me that a lot of well educated, very bright people read and contribute to RMD. Thank you very much for the truly enlightened
comments from all. Seniors everywhere can thank their lucky stars such as you are working in their behalf. I’m honored to play a tiny part in this Industry and am able to read and study the comments.
James E. Veale, CPA, MBT

Mr. Torres,

You have the right to interpret IRC Regulation Sections 1.451-1 and 1.451-2 any way you want. How you reach the conclusion they deal with unearned income or can be used in determining if loan proceeds are income, I have no idea. What I object to is that somehow I will conclude what you do if loan proceeds can be used without limitation or restriction because quite frankly I do not.

Right now borrowers are permitted to use HECM loan proceeds without limitation or restriction. They can take them in the form of currency, foolishly shred and burn them without the incursion of any income tax liability. They can even donate the proceeds to the federal government and obtain a charitable donation with no income tax liability as a result of their unrestricted and unlimited use. I certainly do not recommend either use of HECM proceeds but such use does not result in any income tax liability. Using the proceeds to purchase tangible goods can result in sales taxes and even hidden and stated excise taxes. Gifting them to others might result in gift taxes. But none of these uses result in income taxes.

If any income tax liability is incurred on proceeds it is when proceeds are paid by the lender either to the borrower or on behalf of the borrower and the amount due on the HECM at the time of such payment exceeds the value of the house. However, as indicated by the National Office of the IRS, this is not currently perceived as a taxable event even though many experienced tax professionals reach just the opposite conclusion. As a practical matter though, it would be very, very difficult to enforce.

My conclusions are based 38 years experience in the tax field as a current California CPA and a former Enrolled Agent holding both a degree in accounting and a masters degree in business taxation. As a former math major at UCLA, I agree with your views on mathematics. But having been a geophysical technician at Chevron Geophysical and worked at Fluor Corp., I believe that the practical business world of physics and engineering are much more governed by the “established laws and regulations devised by men” than you indicate.
Abel Torres (eqqmc2)

Mr. Veale,

I guess we are not going to come to an agreement here. I have just been trying to provide an avenue for understanding for our readers even if we are in disgreement. I still say you are missing the point of my original reply. In reponse to your comment “How you reach the conclusion they deal with unearned income or can be used in determining if loan proceeds are income, I have no idea” please understand that I am trying to derive or deduce the logic for the very same conclusion you arrived based on accounting and to certain extent economic and financial fundmentals. As an example look at how SS determines what is considered income for their purposes:
http://www.ssa.gov/OP_Home/rulings/ssi/03/SSR92-08-ssi-03.html
Here I quote:
“A loan means an advance from lender to borrower that the borrower must repay, with or without interest” and “Any advance an SSI applicant or recipient receives that meets the above definition of a loan is not income for SSI purposes since it is subject to repayment”
Now please dont use the paradigm that this is applies to SSA only and the previous discussion to IRS, only. The important thing here is that both agencies look at loan proceeds from the perpective of having some type of repayment or condition attached for receipt of the proceeds. This should not be very complicated to understand. I am not a CPA myself, but it is obvious that the government has a certain logical argument when it comes to treating loan proceeds as income or not.It is not a just a “biased” approach. Please, do not misinterpret my words in this conversation. I am in no way, shape or form putting your credentials in doubt. I could go ahead and provide my resume (in terms of govenment agencies and private industry I have worked for in the past as well as high or low profile projects I have been involved with) here but this is not about our credentials, but about making our readers more aware of relevant issues. Bottom line is that we both agree that reverse mortgage proceeds should not be treated as “income” even if we look at thru different lenses and even if we failed to understand or appreciate each others point.

Have a good night
James E. Veale, CPA, MBT

Mr. Torres,

The most significant portion of the quotation you cite is the following: “…a loan is not income for SSI purposes….” The quotation is of little value except in the context of Social Security determinations since this is the context of the analysis and remarkably in this case, the author acknowledges this limitation. Such honesty is refreshing. Even if the author had reached just the opposite conclusion it would be of the same value since the author is attempting to analyze loans in light of Social Security principles.

I know of no one in the reverse mortgage industry who states: “A reverse mortgage is an exchange of equity for streams of income for SSI purposes.” I also know of no one who says: “A reverse mortgage is an exchange of equity for streams of taxable income.” Therefore, analyzing loan proceeds in light of either IRS or SSA documents is not extremely relevant to the topic presented in the article. No matter how sound the analyses, there is an underlying bias in these agencies’ documents to make determinations in light of the underlying principles governing each of these agencies.

Analyzing court decisions of the state where the property lies that dealt with underlying economic principles would be far more relevant. Unfortunately, I am writing to a national audience and state specific cases are of questionable value.

I appreciate your comments. You are free to present the information you have. But please give me the liberty and space not to agree with your analyses or conclusions in light of the article; you certainly are free to disagree with mine. I am but one contributing commentator. My credentials are only relevant to the topic at hand. I have limited experience on many matters including Social Security. If you believe your credentials are relevant, please list them.
Mike Broderick

Thank you for bring clarity to this industry. If one can not accurately explain the concept of a reverse mortgage, then that person does not really understant the concept.

Are Reverse Mortgage Proceeds Really Income?

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