One of the most perplexing aspects of the Home Equity Conversion Mortgages (HECMs) is the income tax consequences of forgiving (or canceling) any portion of the balance due through short sale, foreclosure, trustee’s sale, or deed in lieu of foreclosure. (This article does not address the income tax consequences of abandonments.) The complexity stems from the nonrecourse nature of reverse mortgages and the promise that no deficiency judgment can be obtained against the mortgagor or heirs. However, the “no liability” promise does not extend to income tax consequences to borrowers or successor owners of the property who receive their ownership as the direct result of the death of the borrower.
Unless otherwise noted, the word “foreclosure” as used in this article includes short sales, trustee’s sales, deeds in lieu of foreclosure, foreclosures, and all other similar forms of transfers of homes (except abandonments) where at time of transfer the amount due on a HECM is greater than the value of the home (net of all liens having a higher priority above the HECM).
HECM Proceeds Can Be Taxable
Reverse mortgage proceeds can become taxable if any portion is forgiven by the lender. If nonrecourse debt is forgiven in a transaction other than sale such as loan modification, it will generally have the same tax ramifications as the forgiveness of recourse debt which is taxable as ordinary income under Section (§) 61(a)(12) of the 1986 Internal Revenue Code as Amended (IRC). A portion or all of the resulting income may be excludible under IRC § 108.
Foreclosure is considered a sale of the underlying property for income tax purposes. Under IRC Regulation § 1.1001-2, the sales price of the property is the sum of nonrecourse debt forgiven plus the fair market value of the property at the time of foreclosure.
Some theoreticians argue that HECM proceeds are not taxable in foreclosure as long as the total of the accrued but unpaid 1) monthly servicing fees, 2) FHA insurance fees charged on the outstanding balance (not upfront fees since they reduce available proceeds), and 3) interest exceeds the amount forgiven. There is no such argument when the amount forgiven exceeds that total.
A few taxpayers claim to have successfully argued in IRS audit that since FHA insurance proceeds were used to pay the shortfall and they paid for the policy with after-tax dollars, FHA insurance proceeds are nontaxable and the payoff falls outside of the foreclosure provisions. They refer to the income taxation of proceeds from life insurance policies in the event of death, medical insurance, and property casualty insurance. Since all of these situations are excludible by specific tax provisions, the argument has little substance and no legal precedence. As will be seen if these loans were HECMs, the audit “winners” might have been overall tax losers.
For example, assume a mortgagor owes $350,000 on a HECM but the appraised value of the home is only $250,000 when the mortgagor surrenders the deed in lieu of foreclosure in 2009. The mortgagor purchased the home in 1974 for $55,000 and spent $50,000 in renovations; however, the mortgagor deferred gains from prior sales of $37,000 — under former § 1034 of the IRC — for an adjusted tax basis of $68,000 (i.e., $55,000 + $50,000 – $37,000). This has been and continues to be his sole and principal residence since 1974. For tax purposes the sales price from foreclosure would be $350,000 [i.e., $250,000 (appraised value) plus the $100,000 from the nonrecourse debt forgiven]. The tax gain would be $282,000 (i.e., $350,000 – $68,000).
Determining gain is not the end of the story. Other income tax provisions may apply. By way of illustration, if the mortgagor in the example is single and meets all of the exclusion rules under the exclusion of gain on the sale of a principal residence provision of IRC § 121, he could exclude $250,000 of the gain leaving only $32,000 to be recognized as a long-term capital gain.
If instead the mortgagor had bought the house for $370,000 in 2005, had done no improvements, and had no prior gains deferred under IRC former § 1034, the adjusted basis of the home would be $370,000. The foreclosure loss would be $20,000 (i.e., $350,000 – $370,000) and as a loss from the sale of a principal residence is a non-deductible personal loss which cannot offset taxable gains or be deducted in any way.
So as can be seen, the amount forgiven on a HECM is no indication of the amount of gain or loss to be recognized upon foreclosure. This is unlike the ordinary income rules governing forgiveness of debt on 1) all recourse loans and 2) those nonrecourse loans where the underlying property is not transferred (such as loan modification); these rules are not presented in this article.
A Benefit from the Tax Foreclosure Computation
To the extent that accrued but unpaid interest is reflected in the sales price in computing the foreclosure gain or loss, such interest is treated as paid. Generally, only paid interest can be used in computing deductible home mortgage interest for itemized deduction purposes. Computing the deductible portion of paid home mortgage interest is a subject for a different article and, therefore, is deferred.
Using the examples above, imagine that of the $100,000 forgiven, $94,000 is accrued but unpaid interest. The total accrued but unpaid interest is $110,000. After working through all of the home mortgage interest rules, $70,000 turns out to be deductible. (For purposes of this example, it is assumed that none of the accrued but unpaid MIP would be deductible.) In the first case, the recognizable gain is $32,000 but the deductible interest exceeds that amount. Long-term capital gains are taxed at a preferential income tax rate while itemized deductions are deductible first against ordinary income which is generally taxed at higher rates. As to the second, although the tax loss from foreclosure is not deductible, the interest is. Unfortunately (or maybe fortunately) not all seniors (or heirs) have the income to effectively utilize this deduction in one tax year. That is why tax planning is highly recommended for HECM and proprietary reverse mortgage borrowers.
Conclusion and Advice Disclaimer
While reverse mortgage proceeds may not always be non-taxable, the story does not always have a bad ending. Advising clients to see their tax advisor may easily earn originators the gratitude of the borrower, heirs, and, of course, the tax advisor. To cover this subject adequately, other topics should be addressed including compliance, foreclosure following the death of the borrower, and how borrowers can help heirs avoid the tax consequences of foreclosure.
James E. Veale, CPA, MBT is the SVP of Tax and Government Affairs & Director of Originator Recruiting for Security One Lending
The purpose of this article was to make readers aware of income tax consequences related to HECM liabilities forgiven in a taxable transfer of a home securing the HECM. The IRS requires that readers be advised that this article cannot be relied upon to mitigate tax penalties. Short sales, abandonments, foreclosures, trustee’s sales, or deeds in lieu of foreclosure are potentially complex income tax transactions and homeowners involved in such transactions should seek the advice of tax professionals who are competent, knowledgeable, and experienced in such matters.Email This Post Print This Post
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