Kitces: Deducting in reverse
The appeal of a reverse mortgage is that it allows homeowners to borrow against their primary residence’s value without making any ongoing payments. Interest simply accrues on top of the principal, and most commonly is not repaid until the homeowner either moves and sells the home, or when it is sold by heirs after the original owner passes away.
However, borrowers (and their advisers) often overlook the tax implications of reverse mortgages — which if not planned for, can cause subsequent mortgage interest tax deductions to be lost for the borrower or his/her heirs. Consequently, it’s essential to coordinate a reverse mortgage with the rest of a client’s tax- and estate-planning strategies.
One of the most popular selling points of a home equity conversion Mortgage, or HECM, is that the money received is tax-free.
In reality, this is simply because a reverse mortgage is nothing more than a loan against an existing asset — regardless of whether the reverse mortgage is an upfront lump sum, a line of credit that’s drawn against periodically or structured as tenure payments for life - making it no more taxable (as income) than a loan to buy a car or pay for college, or a home equity line of credit or a loan against a life insurance policy.
Nonetheless, the fact that a reverse mortgage isn’t treated as income also means it doesn’t (adversely) impact other tax-related issues for retirees, such as the taxability of Social Security payments or income-related premium surcharges for Medicare Parts B and D. While it might be called “income” for household cash flow purposes, the fact remains that it’s really just a loan — albeit one subject to special terms and borrowing requirements.
DEDUCTIBILITY OF INTEREST
While the tax treatment of drawing against a reverse mortgage is rather straightforward, determining deductibility of reverse mortgage interest is far more complex.
The standard rules under IRC Section 163(h) state that personal interest is not tax-deductible. But there is an exception under IRC Section 163(h)(3) that allows a deduction for payments of “qualified residence interest” — i.e., mortgage interest that is classified as either “acquisition indebtedness” or “home equity indebtedness.”
Acquisition indebtedness is a mortgage debt incurred to acquire, build or substantially improve either a primary residence or a designed second home. Home equity indebtedness describes any mortgage debt against a primary residence or second home that doesn’t qualify as acquisition indebtedness.
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The classifications of mortgage debt are significant. Interest on the first $1 million of acquisition debt principal is deductible, but taxpayers can only deduct the interest on the first $100,000 of home equity indebtedness. Additionally, interest on home equity indebtedness is an AMT adjustment, which means the deduction is lost entirely for those already paying AMT.
Notably, the rules classifying mortgage debt are based not on what the mortgage is called by the lender, but how the loan proceeds are used. Thus, a home equity line of credit to expand the home is acquisition debt, but a cash-out refinance of a 30-year mortgage used to consolidate and repay credit card debt is home equity indebtedness — at least for the additional cash-out portion of the loan.
Meanwhile, a mortgage taken out when a primary residence is purchased is acquisition debt, given the loan was used to buy the property. However, if the owner buys the property with cash and later does a cash-out refinance for the same mortgage amount and terms, he/she will have the interest treated as home equity indebtedness because the loan proceeds weren’t used to acquire the residence.
Furthermore, Under Treasury Regulation 1.163-10T(c)(1), mortgage interest deductibility is further limited to a debt balance that doesn’t exceed the original purchase price of the home. Thus, if the original purchase price was $300,000 and a home expansion increased the adjusted purchase price to $350,000, the owner can never deduct mortgage interest on more than $350,000 of mortgage debt. In most typical traditional mortgage situations, this is a non-issue, as the mortgage would typically start at $300,000 or less, and amortize downward over time.
The classifications of deductible mortgage debt are significant.
However, issues arise if the house appreciates and a subsequent cash-out refinance increases the mortgage balance above the original purchase price, plus improvements. And it can also be a limiting factor for negative amortization loans, where the interest compounds against the loan balance over time.
DEDUCTING MORTGAGE INTEREST
A reverse mortgage is still indebtedness against a primary residence, which means the same rules apply to deduct reverse mortgage interest. This includes the determination of whether the loan balance will be classified as acquisition debt or home equity indebtedness. However, there’s an important caveat: Under IRC Section 163(h), mortgage interest is only deductible when it’s actually paid.
That’s a big deal for a reverse mortgage, because the borrower is typically not making any interest (or other) payments on an ongoing basis. Yet if the mortgage just accrues and compounds, there can be no interest deduction on a year-by-year basis.
Instead, the cumulative loan interest is often repaid when the reverse mortgage finally terminates — either because the borrower ceases to use the property as his/her primary residence, decided to repay the loan, or because he/she passed away and the property is being liquidated by the estate or heirs to repay the loan.
RECOVERING LOST DEDUCTIONS
The problem with the typical lump-sum repayment of a reverse mortgage is that when the cumulative loan interest is repaid all at once — and thus claimed as a deduction all at once —the accrued debt might exceed the adjusted purchase price of the property. Furthermore, if the taxpayer doesn’t have enough income to be offset in that particular tax year, much of the deduction could be lost entirely.
In their Journal of Taxation article “Recovering a Lost Deduction,” Sacks, et al., explore how to avoid losing the tax benefits of the reverse mortgage interest deduction in these lump-sum repayment scenarios.
The most straightforward is, in the tax year the reverse mortgage will be repaid, the owner should create taxable income that can then be absorbed by the mortgage interest deduction. This might be accomplished with an IRA distribution, a partial Roth conversion, or simply by ensuring the owner’s total income from other sources is sufficient to fully offset the available deduction.
If the primary residence has appreciated such that there’s a capital gain, even after the up-to-$500,000 capital gain exclusion for the sale of a primary residence, the excess gains can also potentially be offset by the mortgage interest deduction. And while the deduction is less valuable when applied against a capital gain instead of ordinary income, it’s still better than being lost altogether for lack of sufficient income.
If the original homeowner dies, however, a question arises: Who gets to claim the interest? Not the deceased homeowner anymore. Instead, it’s now a tax issue for the estate or heirs.
Fortunately, Treasury Regulation 1.691(b)-1 allows a decedent’s prospective deductible items not paid at death to be deducted when paid by beneficiaries. However, in many cases, the beneficiaries lack sufficient income to be offset by the mortgage interest themselves, especially when most assets get a step-up in basis, and the estate inherits the house to liquidate, but doesn’t inherit pre-tax retirement accounts that might have created taxable income.
Taxpayers can also potentially deduct mortgage insurance premiums (MIPs) as mortgage interest.
Accordingly, one must consider who will inherit a property subject to a reverse mortgage that might be repaid after death, and whether he/she will have sufficient income to offset or absorb the available deduction.
Alternatively, the borrower can avoid the potential clustering of the reverse mortgage’s interest deduction payment at death by voluntarily paying the interest annually (though notably, payments are first applied against accrued mortgage insurance premiums and aggregate servicing fees anyway). And such ongoing repayments might not be manageable, either, depending on the retiree’s cash flow.
Mortgage interest payments are also only deductible when the borrower actually itemizes deductions — which isn’t always the case for retirees, especially if the standard deduction is increased in 2017 and beyond under President Trump’s or the House GOP’s tax reform proposals.
Thus, if the standard deduction is high enough (now, or after tax reform) that itemized deductions are indirectly curtailed for many retirees, it might be more desirable to simply allow the mortgage interest to accrue — though again, it’s still necessary to ensure sufficient income in that liquidation/repayment year to actually absorb the full deduction.
Aside from the potential deduction for a reverse mortgage’s interest payments, taxpayers can also potentially deduct mortgage insurance premiums (MIPs) as mortgage interest under IRC Section 163(h)(3)(E). However, to claim the MIP deduction, it’s necessary that the mortgage itself have been issued since January 1st of 2007, and that the reverse mortgage debt itself be classified as acquisition indebtedness and not home equity indebtedness… which means
the deductibility of the MIP depends on how the proceeds of the reverse mortgage are actually being used. And the impact can be substantial, given that reverse mortgages have both an upfront MIP of 0.50% to 2.50% and an ongoing MIP of 1.25%.
Again though, payments — whether for mortgage interest or mortgage insurance premiums — are only deductible when actually paid, meaning that when the upfront MIP is rolled into the reverse mortgage balance and the annual MIP accrues on top, payments haven’t been made and the MIP cost can’t be deducted.
Instead, if the payments aren’t made until the property is liquidated and the mortgage is paid off in full, the MIP will solely be deductible at that time, all at once, and face the same threshold issue regarding sufficient income to absorb the deduction.
The MIP deductibility situation is further complicated by an income phase-out, which kicks in as income goes above $100,000 of adjusted gross income (for both individuals and married couples filing jointly), with a full phase-out above $109,000. Thus, if the MIP deduction comes due all at once, from a big liquidation that triggers a big capital gain, it may create income against which the deduction would be offset — pushing the taxpayer over the line where none of the MIP is deductible.
In practice though, these constraints may prove moot, as the deduction for mortgage insurance premiums was extended last under the PATH Act of 2015 through the end of 2016, and lapsed as of December 31, 2016. Of course, it may be reinstated later in 2017; it has already been reinstated retroactively after lapsing more than once in the past decade. Alternatively, it could become a matter of permanent tax law under looming 2017 income tax reform.
Still, as it stands now, MIP payments aren’t even deductible in 2017, much less in a distant future year when the property is finally sold and the reverse mortgage is liquidated. And even if the deduction gets reinstated and sticks around, it may be a hassle to calculate how much of the (cumulative) payments are deductible, as unfortunately
the relative balances of mortgage insurance premiums, interest and principal are not directly tracked in the current Form 1098 reporting from the lender. at best, balances would have to be determined, or reconstructed retrospectively, from monthly reverse mortgage statements.
REAL ESTATE TAX IMPLICATIONS
One final point of complexity with a reverse mortgage is how to handle real estate taxes.
In general, the deductibility follows the normal rules under IRC Section 164: The taxes are deductible when actually paid. Thus, regular payments for real estate taxes through a mortgage servicer — as part of the full PITI monthly payment — are still deductible because they were actually paid, even if through the servicer’s escrow arrangement. And a direct payment of real estate taxes is also deductible when paid.
From the tax code’s perspective, it’s irrelevant how the taxpayer got the money; all that matters is the payment.
And the favorable treatment stands when using a reverse mortgage to generate cash to make a real estate tax payment — whether by drawing against the home equity line of credit, using the lump-sum proceeds of a cash-out reverse mortgage, or via the ongoing tenure payments structure. From the tax code’s perspective, it’s irrelevant how the taxpayer got the money; all that matters is that the payment occurred and a real estate tax obligation was paid.
The situation is somewhat more ambiguous for real estate taxes paid directly from the HECM reverse mortgage, which can happen when taxpayers fail to meet underwriting requirements and have a Life Expectancy Set Aside (LESA).
The LESA rules are intended to ensure that reverse mortgage borrowers don’t unwittingly default on the loan by failing to make property tax and homeowner’s insurance payments. Instead, those amounts are drawn directly from the mortgage and are then held in in escrow. Payments for taxes and insurance are then appropriately remitted.
The LESA rules ensure that the borrower doesn’t max out the reverse mortgage borrowing limit for other purposes, and then leave themselves unable to pay property taxes (and homeowner’s insurance), which could trigger a default. Instead, the reverse mortgage borrowing capacity is carved out to pay the taxes and insurance, and the homeowner remains responsible for the rest of his/her bills — albeit without property taxes and homeowner’s insurance looming.
The problem, though, is that in the LESA scenario, the taxpayer never actually makes a personal payment for property taxes, which raises questions about its deductibility. Nonetheless, some argue that given the legal tax obligation is satisfied and the taxpayer incurs an actual debt — that is, an increase in the reverse mortgage balance — it should still be constructively treated as a payment for tax purposes at the time the property taxes are paid via the reverse mortgage, even if it wasn’t a personal cash outflow for the homeowner.
But there is no definitive tax guidance to clarify the treatment, or more clearly distinguish why an increase in reverse mortgage debt balance for interest is not deductible, while a similar increase in the debt balance for a payment of real estate taxes might be deductible.
The bottom line: it’s important to be aware of the potential traps and pitfalls on the tax deductibility associated with reverse mortgages. While the standard rules for deductibility mortgage interest, insurance premiums, and real estate taxes remains, the involvement of a reverse mortgage necessitates more in-depth tax planning and coordination.