For seniors who want to tap into the equity in their homes, reverse mortgages are an option. They can provide a convenient source of cash for those who are house-rich but cash-poor. And there can be a big tax-saving bonus. Here’s what you need to know about reverse mortgages, including the tax angle.
Reverse mortgage basics
With a reverse mortgage, the borrower doesn’t make payments to a lender to pay down the mortgage principal over time. Instead, the reverse happens. The lender makes payments to the borrower and the mortgage loan principal gets bigger over time. However, the maximum initial loan principal amount is limited to a percentage of the appraised value of the home that secures the mortgage.
As it accrues, the interest on a reverse mortgage is added to the loan principal. The borrower doesn’t have to make any interest or principal payments until required under the terms of the loan. Typically, no payment is due until the borrower dies or permanently moves out of the home. You can receive 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 cash. After the homeowner dies or permanently moves out, the property is sold, and the reverse mortgage balance, including the accrued interest, is paid off out of the sales proceeds.
So, with a reverse mortgage, the homeowner can keep control of the property while converting some of the equity into cash. In contrast, if you sell your residence to free up necessary cash, it could involve an unwanted relocation and a big income tax hit if the place has appreciated substantially in value.
Seniors often cannot qualify for conventional “forward” home equity mortgages due to low income. But they can qualify for reverse mortgages. However, as with any major borrowing transaction, it’s important to find a good interest rate and acceptable up-front charges. Up-front charges for a reverse mortgage can be higher than costs for a conventional mortgage.
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These days, most reverse mortgages are home equity conversion mortgages, or HECMs, which are insured by the federal government. You must be at least 62 years old to qualify. As this was written, the maximum amount that can be borrowed under an HECM is $822,325. That limit is up a bunch from just a couple years ago, reflecting surging home prices. The exact lending limit depends on the value of your home, your age, and the amount of any other mortgage debt against the property. To give you an idea, a 65-year-old can usually borrow about 25% of his or her home equity. The percentage rises to about 40% if you’re 75 and to about 60% if you’re 85.
Interest rates can be fixed or variable depending on the deal you sign up for. Rates are somewhat higher than for regular home loans, but not a lot higher.
House-rich but cash-poor and exposed to inflation
Many seniors own hugely appreciated homes but are short of cash. Inflation makes things worse, and it doesn’t look like it’s going to get better anytime soon.
An unwelcome side effect of owning a hugely appreciated home is the fact that selling the property to raise cash can trigger a taxable gain well in excess of the federal home sale gain exclusion break — up to $500,000 for joint-filing couples and up to $250,000 for unmarried individuals. The federal and state income tax hit from selling could easily reach into the hundreds of thousands of dollars, and all that tax money would be gone forever.
Thankfully, there’s a potential solution that involves taking out a reverse mortgage on your property instead of selling. That way, you can take advantage of the tax-saving basis step-up rule explained below.
Basis step-up to the rescue
If you continue to own your residence until you or your spouse passes away, the result could be a greatly reduced or maybe even completely eliminated federal income tax bill when the property is eventually sold. This taxpayer-friendly outcome is thanks to Section 1014(a) of our beloved Internal Revenue Code. That provision allows an unlimited federal income tax basis step-up for appreciated capital gain assets owned by a person who passes away. The Biden tax plan initially included a proposal to greatly cut back the basis step-up break, but that idea has been abandoned.
Here’s how the basis step-up rule works. The federal income tax basis of most appreciated capital gain assets owned by a deceased individual, including personal residences, are stepped up to fair market value (FMV) as of the date of death or the alternate valuation date six months later, if the estate executor chooses that option. When the value of an asset eligible for this favorable treatment stays about the same between the date of death and the date of sale by the decedent’s heirs, there will be little or no taxable gain to report to the IRS — because the sales proceeds are fully offset (or nearly so) by the stepped-up basis.
How does the basis step-up rule usually work with a residence?
Here’s how the basis step-up rule plays out in the context of a greatly appreciated principal residence.
If you’re married and your spouse predeceases you, the basis of the portion of the home owned by your departed mate, typically 50%, gets stepped up to FMV. This usually removes half of the appreciation that has occurred over the years from the federal income tax rolls. So far, so good. If you then continue to own the home until you pass away, the basis of the part you own at that point, which will usually be 100%, gets stepped up to FMV as of the date of your death (or the alternate valuation date if applicable). So, your heirs can then sell the property and owe little or nothing to Uncle Sam.
If you’re unmarried and own the home by yourself, the tax results are easier to understand. The basis of the entire property gets stepped up to FMV when you pass on, and your heirs can then sell the residence and owe little or nothing to the Feds.
There are special basis step-up rules in community property states
If you and your spouse own your home as community property in one of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin), the tax basis of the entire residence is stepped up to FMV when the first spouse dies (not just the 50% portion that was owned by the now-deceased spouse). This weird-but-true rule means the surviving spouse can sell the home shortly after the spouse’s death and owe little or nothing to Uncle Sam.
In other words, if you turn out to be the surviving spouse, you need not hang onto the property until death to reap the full tax-saving advantage of the basis step-up rule. But if you want to hang on, there’s no tax disadvantage to doing so.
How does the reverse mortgage strategy work?
As you can see, holding onto a hugely appreciated residence until death can save a ton of taxes thanks to the basis step-up rule. However, if you need cash right now to make ends meet, we have not yet solved that part of the equation. Enter the reverse mortgage strategy.
As stated earlier, a reverse mortgage does not require any payments to the lender until you move out of your home or die. At that time, the property can be sold, and the reverse mortgage balance paid off out of the sales proceeds. Any remaining proceeds go to you or your estate. If your heirs would like to keep your home instead of selling it, they must pay it off the with another source of funds.
Alternatively, your heirs can pay off the reverse mortgage and keep the property along with the basis step-up. With an HECM, your heirs will never have to pay more than the loan balance or 95% of the home’s appraised value, whichever is less. Nice.
What are the fees on a reverse mortgage?
Fees to take out and maintain a reverse mortgage will usually be considerably higher than for a regular “forward” home equity loan or line of credit. With an HECM, you will usually pay an origination fee equal to 2% of the first $200,000 of your home’s value plus 1% of any value above $200,000. However, the origination fee 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 due to value. The MIP has both an initial payment based on the property value and an annual renewal based on the outstanding loan balance.
In addition, the lender can charge a modest monthly servicing fee. Typically, you will also have to pay the familiar third-party home mortgage closing costs for things like title insurance, an appraisal, settlement services, and so forth. These costs are tacked onto the initial reverse mortgage balance and reduce your available loan proceeds.
You’ll need to do some research to find the best product for your specific circumstances.
Can I deduct the interest on a reverse mortgage used to free up cash?
Not under the current federal income tax rules. Under the 2017 Tax Cuts and Jobs Act (TCJA), the interest on home equity loans, which include reverse mortgages, is nondeductible for 2018-2025.
The bottom line
You might object to the notion of borrowing against your home to solve a cash shortage. Fair enough, but the cash you need must come from somewhere. If it comes from selling your hugely appreciated home, the cost of getting your hands on the money will be a big tax bill.
In contrast, if you can get the cash you need by taking out a reverse mortgage, the only cost will be the fees and interest charges. If those fees and interest charges are a small fraction of the taxes that you could permanently avoid by continuing to own your home, the reverse mortgage strategy can make perfect sense.
This article was originally published by Marketwatch.com. Read the original article here.