Two Vital Reverse Mortgage Tax Resources

The unusually late tax day of April 18 may have come and gone, but reverse mortgage professionals know that questions about the tax implications of Home Equity Conversion Mortgages don’t have a deadline. In the days leading up to the federal tax deadline, two prominent financial planning writers featured pieces that can help explain these issues to potential borrowers year round.

Over at Nerd’s Eye View, writer Michael Kitces goes long on the ways that reverse mortgage proceeds can and can’t get a borrower into murky tax waters. The short answer is they generally cannot: Because proceeds from a reverse mortgage are simply a loan, Uncle Sam can’t and won’t levy taxes on HECM checks.

“No income or wealth is created in the first place; the borrower is simply taking out a personal loan and using his/her primary residence as the collateral, which isn’t any more taxable than getting a loan to buy a car or pay for college, or taking out a home equity line of credit or borrowing against a life insurance policy,” Kitces writes.


Tax Deductions Become Interest-ing

Things become slightly more difficult, however, when the question of reverse mortgage interest comes up. That’s because the tax code doesn’t care what type of loan you have when it comes to deducting interest, but only the reason that you’re using the loan. The key distinction, as both Kitces and personal-finance blogger Tom Davison write, is between “acquisition indebtedness” and “home equity indebtedness.”

Before your eyes glaze over, keep in mind that this subtle wordplay can mean the difference between a deduction of $100,000 and $1 million. Put simply, you can deduct interest on up to the first million bucks of “acquisition indebtedness,” or any money borrowed against a home that you then use to buy, build, or “substantially improve” a first or second property. But if you simply take out a loan to spend the proceeds on other things, such as home health care or day-to-day expenses, suddenly you’re in regular “home equity debt,” and you can only deduct the interest on the first $100,000.

Clearly there are many more factors at play, and RMD doesn’t purport itself to be an exhaustive tax-law resource — for instance, you can’t claim home equity indebtedness deductions if you pay the alternative minimum tax — but a high-level understanding of HECM tax implications is important, as many originators and brokers cite taxes as a major source of questions that they field from prospective and current borrowers.

Using Reverse Mortgage Payments to Your Advantage

The fact that borrowers don’t have to make any payments is often highlighted as one of the key benefits of reverse mortgage products for older Americans. But in a frequently updated post on his blog,, Davison posits that making interest payments in certain years could have tax benefits: For instance, if a borrower is required to take a required minimum distribution from a retirement account, he or she could suddenly end up in a higher tax bracket for a given year. A payment toward the reverse mortgage principal could result in a deduction that helps counteract the effects of the higher bracket, Davison writes.

Kitces takes the discussion a step further on his blog, noting that borrowers — or their heirs — can claim a substantial interest deduction in the year that they pay off the reverse mortgage in its entirety, either through the sale of the house or some other means. In some cases, Kitces writes, it then might actually be the borrower or heir’s interest to create income to take full advantage of the sizable deduction, either through taking money out of an IRA or a partial Roth conversion.

Read the Full Posts for More

Both Kitces and Davison’s pieces are must-reads for anyone who works with current or curious borrowers, and for their full looks into the potentially confusing world of reverse mortgage tax deductions, visit Nerd’s Eye View and Tools for Retirement Planning.

Written by Alex Spanko

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  • Mr. Kitces’s article is little more than a summary of the Dr. Barry Sacks’s article, while Dr. Davison’s does not emphasize the impact of temporary reg 26 CFR 163-10T(c). None of the articles address an IRS Memorandum (Number 201201017) which for some taxpayers can be far more lenient than the articles referenced above.

    The IRS Memorandum can be found on the IRS website at:

    Even though there is a clear warning about using IRS Memorandums in citations in the Memorandum, it is extremely difficult for the IRS to attack their own reasoning found in these documents. The IRS wants wiggle room but nonetheless, it rarely takes positions that differ from those found in these type documents. These documents give one some sense on how the IRS will attack or not attack the issues covered. The Memorandum is extremely taxpayer friendly when it comes to interest on the home that can be deductible for other purposes when some or all of proceeds are used for that purpose.

    Mr. Marty Bell provided examples of uses of proceeds by borrowers in a NRMLA Reverse Mortgage magazine published some years back. One borrower used proceeds to create a photo store. Of course, there was insufficient information to determine what type of tax entity was selected for owning the operating enterprise and if the proceeds were used for other purposes. But if all the proceeds were used for the business and the business was either a sole proprietorship or a LLC (or some other eligible entity) electing to be taxed as a sole proprietorship, not only could that make some or all of the interest be deductible as an expense for income tax purposes but also for self employment tax purposes as well. It is also possible that the business interest portion of the loan could be deducted on the accrual method of accounting. Other rules such as at risk rules could apply.

    Besides sole proprietor businesses there are an enormous number of other ways proceeds can be used that will make reverse mortgage interest (and at times MIP) be deductible above the adjusted gross income line. Using and being able to verify proceeds being used in rental activities, oil and gas operations, partnerships, S corporations, and even C corporations can improve the likelihood of deducting a larger portion of interest than home mortgage interest alone might otherwise result in.

    Do not try to become an income tax expert but point these issues out to your income tax and financial planning referral sources and let competent experts think through how these ideas could enhance their tax planning services to their clients.

    On another subject Mr. Kitces covers the deductibility of real estate taxes paid through a LESA. His caution seems unwarranted although one should be looking out for any guidance the IRS might give on the subject. The discussion fails to distinguish between the three types of LESAs, partially funded, voluntarily fully funded and involuntarily fully funded.

    With the partially funded LESA the borrower receives a payment from the servicer to have sufficient cash flow to pay property charges. There should be no question that the payment of real estates in this case is fully deductible in the tax year paid since the liability is that of the homeowner, not the lender or servicer.

    With the voluntary fully funded LESA, since only the homeowner (and neither the lender nor the servicer) is liable for payment, the servicer is acting as the agent for the borrower and thus once again even though the payment is made from borrowed funds, neither the lender nor the servicer are related to the government office collecting the taxes and thus deduction should be permitted in the tax year that the funds are paid by the servicer.

    Finally with the involuntary fully funded LESA, the borrower is mandated to set aside funds. Again since the servicer is acting as the agent of the borrower and the homeowner is liable for payment, real estate taxes should be deductible in the year paid by the servicer.

    Mr. Kitces speaks of guidance from the IRS. Since I personally wrote the guidance from the IRS found in their publication 936 and similar references in IRS literature on the tax year of deduction of reverse mortgage interest as home mortgage interest, it is unlikely we will see any guidance on LESAs for some time. When that guidance comes it should be followed; however, until that guidance comes, if ever, because of the statute of limitations, one should consider carefully in what tax year to deduct real estate taxes paid from a LESA particularly when it comes to involuntary fully funded LESAs. If the IRS releases an opinion on LESAs and that opinion concludes somehow that real estate taxes cannot be deducted until the tax year that payment is made by the borrower on the HECM, then all kinds of problems ensue such as there is no payment allocation rule for real estate taxes paid from LESAs.

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