Rich in house but poor in money? The reverse mortgage could be your tax salvation
For seniors who want to take advantage of their home equity, reverse mortgages are an option. They can be a convenient source of money for those who have a wealthy house but are lacking it. And there can be a big tax saving bonus. Here’s what you need to know about reverse mortgages, including the tax aspect.
With a reverse mortgage, the borrower does not make payments to a lender to pay off the mortgage principal over time. Instead, the reverse is happening. The lender makes payments to the borrower and the mortgage principal increases over time. However, the maximum initial principal amount of the loan is limited to a percentage of the appraised value of the house that secures the mortgage.
As it accumulates, the interest on a reverse mortgage is added to the principal of the loan. The borrower does not have to make any interest or principal payments until the terms of the loan require it. As a general rule, no payment is due until the borrower dies or leaves the accommodation permanently. You can receive the reverse mortgage proceeds as a lump sum, in installments over a period of months or years, or as line of credit withdrawals when you need the cash. After the owner dies or moves permanently, the property is sold and the balance of the reverse mortgage, including accrued interest, is paid off the proceeds of the sale.
So, with a reverse mortgage, the owner can maintain control of the property while converting some of the equity into cash. On the other hand, if you sell your home to free up necessary cash, it could mean an unwanted move and a big impact on income tax if the value of the place has appreciated significantly.
Seniors often cannot qualify for conventional âtermâ home equity mortgages due to their low income. But they may be eligible for reverse mortgages. However, as with any large borrowing transaction, it’s important to find a good interest rate and acceptable upfront charges. The upfront costs of a reverse mortgage can be higher than the costs of a conventional mortgage.
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Most reverse mortgages these days are home equity conversion mortgages, or HECMs, that are federally insured. You must be at least 62 years old to be eligible. As has been written, the maximum amount that can be borrowed under a HECM is $ 822,325. This limit is much higher than just a few years ago, reflecting soaring house prices. The exact loan limit depends on the value of your home, your age, and the amount of any other mortgage debt on the property. To give you an idea, a 65-year-old can typically borrow around 25% of their home equity. The percentage rises to around 40% if you are 75 and to around 60% if you are 85.
Interest rates can be fixed or variable depending on the offer you subscribe to. The rates are a little higher than for traditional home loans, but not much higher.
House rich but cash poor and prone to inflation
Many older people own popular homes but are short of money. Inflation is making things worse and it doesn’t look like it’s going to get better anytime soon.
An unfortunate side effect of owning a highly prized home is the fact that selling the property to raise funds can trigger a taxable gain far greater than the federal exclusion of gains from the sale of a home – up to to $ 500,000 for couples filing jointly and up to $ 250,000 for unmarried individuals. Federal and state income tax affected by the sale could easily run into the hundreds of thousands of dollars, and all that tax money would be gone forever.
Fortunately, there is a potential solution which is to take out a reverse mortgage on your property instead of selling it. In this way, you can take advantage of the tax base gross-up rule explained below.
Base step-up to the rescue
If you continue to own your home until your or your spouse’s death, the result could be a significantly reduced or perhaps even completely eliminated federal income tax bill when the property is finally sold. This taxpayer-friendly result is due to section 1014 (a) of our beloved Internal Revenue Code. This provision allows for an unlimited gross-up of the federal income tax base for appreciated capital gains held by a deceased person. The Biden tax plan initially included a proposal to dramatically reduce the base break, but that idea was scrapped.
Here’s how the basic increase rule works. The federal tax base for the most valued capital gains held by a deceased person, including personal residences, is increased to fair market value (FMV) on the date of death or some other valuation date six months later, if the executor chooses this option. When the value of an asset eligible for this favorable treatment remains roughly the same between the date of death and the date of sale by the deceased’s heirs, there will be little or no taxable gain to report to the IRS – because the proceeds of the sale are fully (or almost) compensated by the increased base.
How the basic mark-up rule usually works with a residence?
Here is how the rule of the basic increase is played out in the context of a very popular principal residence.
If you are married and your spouse predeceases you, the base for the portion of the house owned by your deceased spouse, typically 50%, is increased to fair market value. This typically removes half of the appreciation that has occurred over the years from the federal income tax roll. So far, so good. If you then continue to own the home until your death, the base of the portion you own at that time, which will generally be 100%, is increased to the FMV on the date of your death (or alternative valuation date if in force). So your heirs can then sell the property and owe Uncle Sam little or nothing.
If you are single and own the home on your own, the tax results are easier to understand. The basis of the entire property is increased to fair market value when you die, and your heirs can then sell the residence and owe little or nothing to the federal authorities.
there are specials basic mark-up rules in community property states
If you and your spouse own your home as communal property in one of the nine communal property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), the tax base of the entire residence is increased to fair market value on the death of the first spouse (not just the 50% portion that belonged to the now deceased spouse). This odd but true rule means that the surviving spouse can sell the house soon after the spouse dies and owes Uncle Sam little or nothing.
In other words, if it turns out that you are the surviving spouse, you don’t need to keep the property until your death to take full advantage of the tax benefit of the basic gross-up rule. But if you want to hang in there, there’s no tax downside to doing so.
How the reverse mortgage strategy works job?
As you can see, keeping a highly valued residence until death can save a ton of taxes thanks to the base mark-up rule. However, if you need the cash right now to make ends meet, we haven’t solved that part of the equation just yet. Enter the reverse mortgage strategy.
As stated earlier, a reverse mortgage does not require any payment to the lender until you leave your home or die. At that point, the property can be sold and the balance of the reverse mortgage paid off from the proceeds of the sale. Any remaining proceeds go to you or your estate. If your heirs want to keep your house instead of selling it, they must pay it off with another source of funds.
Alternatively, your heirs can pay off the reverse mortgage and keep the property with the base increase. With an HECM, your heirs will never have to pay more than the loan balance or 95% of the appraised value of the house, whichever is less. Pleasant.
What are the costs of a reverse mortgage?
The fees to take out and maintain a reverse mortgage will generally be considerably higher than for a regular âtermâ home equity loan or line of credit. With an HECM, you will typically pay an assembly fee equal to 2% of the first $ 200,000 of your home’s value plus 1% of any value over $ 200,000. However, origination fees cannot exceed $ 6,000.
You will also be charged a Mortgage Insurance Premium (MIP) to reduce the risk of loss to the Department of Housing and Urban Development (HUD) or the lender in the event of default or loss of value. The MIP has both an upfront payment based on the property’s value and an annual renewal based on the outstanding loan balance.
Additionally, the lender may charge a modest monthly service fee. Typically, you’ll also have to pay the closing costs of third-party residential mortgages for things like title insurance, appraisal, settlement services, and more. These costs are added to the original reverse mortgage balance and reduce your available loan proceeds.
You will have to do some research to find the best product for your particular situation.
Can I Deduct Interest on a Reverse Mortgage Used to Free Up Money?
Not under current federal tax rules. Under the Tax Reductions and Jobs Act 2017 (TCJA), interest on home equity loans, which includes reverse mortgages, is not deductible for 2018-2025.
The bottom line
You might object to the idea of ââborrowing against your home to resolve a cash flow shortage. Fair enough, but the money you need has to come from somewhere. If it comes from selling your much-loved home, the cost of getting your hands on the money will be a big tax bill.
On the other hand, if you can get the cash you need by taking out a reverse mortgage, the only costs will be fees and interest. If those fees and interest are only a small fraction of the taxes you could permanently avoid by continuing to own your home, the reverse mortgage strategy may make perfect sense.