Reverse Mortgages: Key Considerations

Reverse mortgages present a unique financial product enabling homeowners, generally aged 62 and up, to transform part of their accumulated home equity into liquid assets. Unlike typical mortgage arrangements where you make payments to the lender, a reverse mortgage allows the lender to pay you. This can be structured as a lump sum, consistent monthly disbursements, or a line of credit, offering financial flexibility tailored to your needs.

To properly secure a reverse mortgage, it needs to be linked with a first trust deed. Existing loans must be cleared with separate finances, or via the reverse mortgage funds themselves. The borrowing capacity correlates with age—the older the borrower, the larger the potential loan and lower interest rate. Each situation can be complex and heavily depends on current financial obligations.

When settling a reverse mortgage, accrued interest along with the principal must be repaid, and it’s crucial to understand the potential tax implications. Here are key financial and tax considerations associated with reverse mortgages.

Fund Disbursement and Taxation

Tax-Free Status: Regardless of whether you receive the proceeds as a lump sum, via a credit line, or as regular payments, the IRS views them as loan proceeds rather than taxable income.

Social Security and Medicare Eligibility: These payments don't count as income, thereby not affecting your eligibility for Social Security benefits or Medicare provisions.

Interest Deductibility Constraints

Deductibility Timing: Unlike conventional mortgages, interest on a reverse mortgage can be deducted only upon full loan repayment—typically occurring upon home sale or the original borrower's passing.
Interest Reporting: Lenders issue Form 1098 to document interest paid at settlement time.
Eligible Loan Use for Deduction: Interest is generally deductible only if proceeds were utilized for home buying, building, or significant improvements (IRC Section 163(h)(3)). For borrowers who allocated funds towards daily expenses, this deduction may not apply, even post repayment.
Interest Deduction Allocation: The deductibility of reverse mortgage interest, especially when tied to home acquisition, involves multiple considerations. A proration applies when part of the reverse mortgage refinances acquisition debt.
Claiming Deductible Interest: Who claims this deduction can vary:
- The Borrower: If repaid during their lifetime.
- The Estate: If settled by the estate following borrower’s death.
- Heirs: They may claim on personal returns if they settle the debt.

Caveats and Limitations

Debt Ceiling for Deductions: IRS limitations cap deductible interest based on the total debt, with recent loans limited to $750,000, while those pre-2017 can reach $1 million.
Usage Record-keeping: Documentation proving funds were spent on qualifying home improvement is necessary to sustain deductibility claims.

Effect on Means-tested Benefits

Medicaid and SSI Implications: Reverse mortgage funds are regarded as assets, potentially affecting Medicaid and SSI eligibility. To avoid losing benefits, it is advisable to utilize funds within the month of receipt.

Ongoing Obligations for Borrowers

Property-Related Financial Responsibilities: Borrowers are accountable for property taxes, insurance, and associated expenses. Neglect in these areas can result in default or foreclosure.
Financial Assessment by Lenders: Prior to loan approval, lenders evaluate borrowers' ability to manage ongoing obligations. If issues are noted, portions of funds might be allocated to a Life Expectancy Set-Aside (LESA) account to ensure timely payment of these expenses.

Considerations for Beneficiaries

Non-recourse Designation: Significant among reverse mortgages, especially FHA-backed HECMs, is the provision that heirs are not liable for excess debt beyond home value. If the market value doesn't cover the loan, FHA coverage compensates the remainder.
95% Purchase Option: The 95% purchase condition allows heirs to retain the property by paying 95% of its assessed value or the full loan, whichever is less, safeguarding them financially.
Capital Gains Considerations: When selling inherited property with a reverse mortgage, standard capital gains regulations apply, often allowing for a "stepped-up" basis to minimize taxes.

Evaluating the Pros and Cons

Reverse mortgages offer substantial fiscal latitude, yet they bear some disadvantages. As compounded interest accumulates, equity diminishes, impacting borrowers and heirs. Additionally, the obligation for ongoing property-related expenses remains. Failure in this regard can lead to foreclosure.

Moreover, reverse mortgages entail closing costs, potentially exceeding those of conventional loans. For those considering relocation, this might not be an ideal solution. Weighing both benefits and potential downsides is crucial. For tailored advice and further assistance, feel free to contact our office.

Essential Insights on Reverse Mortgages for Homeowners