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, ToolsForRetirementPlanning.com, 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