Nasdaq: How Reverse Mortgages Can Assist Wealthy Seniors’ Tax Plans

The sweeping Tax Cuts and Jobs Act of 2017 changed much about the way that tax laws work in the United States, and also helped to elevate the reverse mortgage product category by enhancing its strategic importance for wealthy seniors seeking to incorporate a new element of strategy into their tax situations. This is according to Harlan Accola, national reverse mortgage director at Fairway Independent Mortgage Corporation in a column published at Nasdaq.

“[The 2017 tax law] has a profound effect on mortgage interest deductibility and actually elevated the reverse mortgage as an enhanced tool for strategic IRA withdrawals, Roth conversions, Net Unrealized Appreciation (NUA), and other strategies centered around deferred or accelerated tax accounts,” Accola writes.

In addition to unifying the standard tax deduction available to everyone regardless of whether a filer chooses to itemize or if they do or do not own a home, one major change focused on the one major deduction that remains allowed on mortgage interest: acquisition indebtedness, Accola explains.

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“Formerly, home equity indebtedness interest was allowed to be deducted on a loan balance of $100,000 that was perhaps a Home Equity Line of Credit (HELOC) or 2nd mortgage,” he says. “So unless you are using the mortgage funds to build, buy, or substantially improve your home, interest is not deductible.”

Importantly, it doesn’t matter what kind of loan is in place for this purpose as long as the money is being, or has been used to either build or buy a new home, or to improve an existing home.

With a reverse mortgage line of credit in place during either a refinance or new home purchase and the full balance is drawn at closing, the line of credit continues to grow to account for the interest accrued on the money being used, Accola says.

“When any payment is made — even if it is only interest — the payment is first applied to the Mortgage Insurance Premium (MIP) and Interest expense before any principal is paid,” he says. “After the payment is made, within a few days, the full amount of the payment — regardless of how it was applied to the loan balance — is made available for the borrower to re-borrow from the line of credit the full amount that was paid.”

This is a strategy that can be used for as long as the client resides in the home, and they keep up with the property’s associated taxes and insurance fees. The line itself is guaranteed in spite of changes to the home value, and remains non-recourse, he says.

For strategic income tax or IRA purposes, letting interest accrue on a reverse mortgage for purchase transaction can let the interest accrue for several years, in which it will negatively amortize and increase the balance in the future.

In terms of accelerating taxes into a new lower rate environment, some advisors feel that the current moment represents the “lowest tax rate baby boomers will see in their lifetime,” Accola says. This means that the current moment could be the most optimal time to engage into a reverse mortgage to pay for taxes on a Roth IRA conversion, he explains.

“A reverse mortgage line of credit is tax free because it is borrowed money so withdrawals can be used at 100% of value to pay the tax due on a reverse mortgage,” he says. “Net Unrealized Appreciation (NUA) on company stocks for people retiring may make sense to be paid in the year they retire instead of over the next 20-30 years. Again the reverse mortgage can be used as a tax free source of funds to pay the lower taxes earlier.”

Read the column at Nasdaq.

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  • As usual those without significant tax experience get things wrong.

    The following is not correct: “‘So unless you are using the mortgage funds to build, buy, or substantially improve your home, interest is not deductible.’”

    If the borrower uses proceeds to pay off an existing forward mortgage, to the extent that the forward mortgage used proceeds in acquisition transactions, the new loan inherits that same characteristic on the proceeds that were used to pay the existing debt. So for example, total closing costs are $18,000 and $200,000 of the available HECM principal limit was used to pay off an existing forward mortgage so that the Unpaid Principal Balance of the HECM was $218,000. In analyzing the prior mortgage, it turns out that $175,000 was acquisition indebtedness. The HECM closed on June 30, 2020. The borrower would treat $175,000 as acquisition indebtedness. Let us say that the average effective interest rate for the six months of the year following June 30, 2020, was 3% which means that for qualified residence interest purposes, the available deduction for calendar tax year 2020 is $2,625 but that is only available for deduction in the tax year it is paid (that is, for most taxpayers). On the forward mortgage there would most likely be interest that is deductible as qualified residence interest for the first half of the tax year as well. The carryover of tax characteristics is known as “grandfathering” in tax lingo.

    The author also did not say that cash basis taxpayers can deduct no more than what they pay in interest on their home mortgages but other tax rules may limit even that such as the acquisition indebtedness rules. Further there are caps on how much indebtedness can qualify as acquisition indebtedness interest. Then there are questions whether the compounded portion of interest that is paid in a tax year is deductible as questioned by Barry Sacks a well respected tax attorney. There are also rules reducing the tax deduction where the unpaid principal balance on a nonrecourse mortgage exceeds the value of the home.

    If the Standard deduction is greater than the total of itemized deductions, in that year any interest paid for deduction purposes on a reverse mortgage is a wasted deduction. This is why techniques such as bunching are crucial to understand and should be employed as needed.

    The following is also entirely false: “Importantly, it doesn’t matter what kind of loan is in place for this purpose as long as the money is being, or has been used to either build or buy a new home, or to improve an existing home.” If the home is not collateral for the loan, the interest cannot be deducted as home mortgage interest no matter how the proceeds are used.

    I have no idea what the last part of the following means: “‘“A reverse mortgage mortgage line of credit is tax free because it is borrowed money so withdrawals can be used at 100% of value to pay the tax due on a reverse mortgage…” What tax is due on a reverse mortgage? The only tax that I know that is due on a reverse mortgage is the intangibles tax in Florida.

    The following is almost right: “‘When any payment is made — even if it is only interest — the payment is first applied to the Mortgage Insurance Premium (MIP) and Interest expense before any principal is paid….”’ For older HECMs, following MIP, the unpaid accrued servicing fees must be paid off before any part of a prepayment is applied to unpaid accrued interest.

    ————————————————

    Rather than further corrections, let us look at some important concepts. Not all of the proceeds related to a H4P automatically qualify as acquisition indebtedness. Only the proceeds that are used to acquire the home and those that are used in making substantial improvements and used for construction projects such as adding a new bedroom, bathroom, inlaw quarters, etc. In some cases where not all the proceeds were used to acquire the home, some might have been used for a child’s wedding, etc.

    It should be pointed out that home equity indebtedness interest is scheduled to return as an itemized deduction for regular income tax purposes (but not alternative minimum tax purposes) in tax year 2026.

    HECM borrowers should realize that there is a limited deduction for the portion of MIP that is related to acquisition indebtedness; however, that deduction is scheduled to terminated on all MIP paid or accrued after December 31, 2020. Since MIP is paid by the servicer to HUD as it accrues, MIP can generally be deducted as accrued. Interest is only paid by borrowers so it is not deductible as accrued with limited exceptions.

    However, reverse mortgage interest can be deducted in other category of activities if the proceeds can be traced to those activities under the reasonably stringent tracing rules of 26 CFR 1.163-8T. The justification for such treatment is found in 26 CFR 1.163-10T(o)(5).

    Then one must define the term “qualified residence.” Under 26 USC
    163(h)(4)(A)(i) “The term ‘qualified residence’ means—
    (I)the principal residence (within the meaning of section 121) of the taxpayer, and (II)1 other residence of the taxpayer which is selected by the taxpayer for purposes of this subsection for the taxable year and which is used by the taxpayer as a residence (within the meaning of section 280A(d)(1)).”

  • “A reverse mortgage mortgage line of credit is tax free because it is borrowed money so withdrawals can be used at 100% of value to pay the tax due on a reverse mortgage,”

    Assume this was a miss-print in the source article; not clear to what “tax due” this reference is made.

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