This article, originally published in the Journal of Taxation, examines the conditions, requirements, and limitations on deductions of the interest accrued on reverse mortgage loans.
Although the conventional approach for passing a borrower’s home equity to heirs generally results in the loss of the deduction for reverse mortgageloan interest, the deduction may be used if it is connected with income, such as when the borrower has a 401(k) account or rolloverIRA.
The main points for the article include:
1. Reverse Mortgages Accrue Interest; No Deduction Until Actually Paid.
Reverse mortgage loans accrue interest, generally over long periods of time. Because essentially all the borrowers are cash basis taxpayers, that interest is not deductible until it is actually paid. Payment is usually, but not always, made when the home securing the loan is sold, often after the borrower’s death. Other conditions and requirements may limit the obligor’s ability to claim the deduction.
2. How the Interest Deduction is Often Lost.
The deduction is lost if the home is sold by a person (or entity) who (or that) does not have sufficient income to be offset by the deduction. In the conventional approach for passing the borrower’s home equity to the heir(s), the executor of the estate will sell the home, pay off the reverse mortgage, and distribute the net proceeds to the heir(s). Because the estate of a typical decedent we are considering has little or no income, the deduction is lost.
3. The Mass Affluent Retirees.
The focus of our attention is on “mass affluent” retirees. Typically, the mass affluent have a net worth at retirement in the range of $1.5 million to $3 million, well below the level where estate tax is a consideration. Most often, this wealth consists primarily of two assets: A securities portfolio (usually in a 401(k) account or a rollover IRA); and a home, in some cases encumbered by little or no debt, and in other cases encumbered by more debt than the retiree can comfortably service. For most mass affluent retirees, these two assets have values that are of the same order of magnitude. (Of the Baby Boomer generation’s 75 million members, close to 15 million are in the mass affluent category.
4. The Major Financial Objectives of the Mass Affluent Retirees.
The major financial objectives of mass affluent retirees area:
A. Cash Flow Survival, i.e., not running out of money during retirement. (The risk of outliving one’s money is often termed the “Longevity Risk.”)
B. Retaining some financial cushion to be available in the event of financial emergency.
C. Passing something on to heirs and beneficiaries. (This objective is often termed the “Bequest Motive.”)
5. Illustrative Examples.
Two illustrative examples are given, each showing two ways a mass affluent retiree can pursue his or her financial objectives.
A. In the first example, a retired homeowner with a large IRA ($1 million) and a large home with a mortgage outstanding, wishes to downsize to a smaller home on which he will have no debt. After selling the current home, he will need about $250,000 to complete the purchase of the new home.
He can obtain it either from the IRA or take a reverse mortgage (“HECM for Purchase”). He will need $40,000 per year (inflation adjusted), plus Social Security, for living expenses (including income taxes). Monte Carlo simulation, using realistic figures, shows that the probability is much higher that all three of the major financial objectives will be achieved if the funds come from the HECM than if the funds come from the IRA.
B. In the second example, a retired homeowner with a $700,000 IRA and a $900,000 home with no debt against it wishes to stay in the home and will need $40,000 per year (inflation adjusted), plus Social Security, for living expenses (including income taxes). He can draw the income from his IRA and/or from a reverse mortgage credit line.
He can use the reverse mortgage credit line as a last resort, or he can use it “strategically,” i.e., to offset the “adverse sequence of returns” risk. Similar to the previous example, Monte Carlo simulations, using realistic figures, shows that the probability is much higher that all three of the major financial objectives will be achieved if the reverse mortgage is used “strategically” than if the reverse mortgage credit line is used as a last resort.
Source: “Recovering a Lost Deduction,” by Barry H. Sacks, Nicholas Maningas, Sr., Stephen R. Sacks, and Francis Vitagliano published in Journal of Taxation, April 2016. Reprinted with permission from the author.
This article should not be construed as tax advice and the reader should consult a tax specialist. For a recommendation, please call (415) 259-4979.