Reverse mortgages can be an option for seniors who wish to access the equity in their homes. Reverse mortgages can be a great way to get cash for people who have a lot of money but are cash-poor. There can also be significant tax savings. This is what you need to know, including the tax aspect, about reverse mortgages.
Reverse Mortgage basics
A reverse mortgage allows the borrower to stop making payments to the lender for the principal of the mortgage. The reverse occurs. Instead, the lender makes monthly payments to the borrower, and the principal on the mortgage loan grows over time. The maximum loan principal amount can only be a fraction of the property’s appraised value.
The interest on reverse mortgages is added to the principal as it accrues. The loan terms don’t require that the borrower make principal or interest payments. The borrower is not required to make any payments until they die or move out of their home permanently. Reverse mortgage proceeds can be received in one lump sum or over several years. You may also receive line-of-credit withdrawals for cash when you are short of cash. The reverse mortgage balance is paid out of the proceeds when the homeowner dies, permanently moves out or the homeowner is no longer able to pay it.
A reverse mortgage allows the homeowner to keep the property and convert some equity into cash. If you decide to sell your home in order to get the cash you need, this could lead to an unwelcome relocation or a large income tax increase if the property has appreciated significantly.
Low-income seniors are often unable to qualify for traditional “forward” home equity mortgages. Reverse mortgages are possible for them. As with all major borrowing transactions, it is important to get a good rate of interest and pay no up-front fees. Reverse mortgages can have higher up-front costs than conventional mortgages.
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Most reverse mortgages today are home equity conversion mortgages (HECMs), which are insured by the federal government. To be eligible, you must be at minimum 62 years of age. The maximum amount you can borrow under a HECM at the time of writing is $822,325. This limit has increased a lot from a few years ago due to rising home prices. The lending limit will depend on your age, the value of your property, and any mortgage debts attached to it. A 65-year old can typically borrow 25% of the equity in his or her home. This percentage increases to around 40% for those over 75 years old and to 60% for those over 85.
Depending on the deal, interest rates can be either fixed or variable. The rates are slightly higher than regular home loans but not much higher.
House-rich, but cash-poor, and subject to inflation
Seniors often have large, well-loved homes but are tight on cash. It’s not looking good for seniors who have a home that is well-loved but is short on cash.
A side effect of having a highly valued home is that you can lose a lot of your federal home sale exclusion break. This includes a $500,000 maximum for married couples and a $250,000 maximum for singles. Selling a home could result in a federal and state income tax loss of hundreds of thousands of dollars. All that tax money would disappear forever.
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There is a solution. Instead of selling your property, you can take out a reverse mortgage. This will allow you to take advantage of the step-up tax-saving rule.
You can keep your home until your spouse dies, and then your federal income tax bill could be greatly reduced or eliminated when you sell the property. Section 1014(a), our beloved Internal Revenue Code, is responsible for this taxpayer-friendly result. This provision provides an unlimited federal income tax basis increase for appreciated capital gains assets that are owned by a deceased person. Biden’s tax plan originally included a proposal for a drastic reduction in the basis step-up break. However, that idea was abandoned.
This is how the basis-step-up rule works. The federal income tax basis for most appreciated capital gains assets owned by a deceased person, including personal residences is stepped up to the fair market value (FMV), as of the date that the individual dies or an alternate valuation date six months later if the executor chooses this option. The IRS will not report any taxable gains if the asset is eligible for this favorable treatment. This is because the sale proceeds are fully or nearly offset by the stepped-up basis.
How does a residence use the step-up rule?
This is how the basis-up rule works in the context of a highly appreciated principal residence.
If you are married and your spouse dies, your spouse’s share of the home, usually 50%, is increased to FMV. This typically removes half the appreciation that occurred over the years from federal income tax rolls. So far, so good. The basis of the property you continue to own until your death, usually at 100%, is increased to FMV (or alternate valuation date, if applicable). Your heirs will then be able to sell the property and owe Uncle Sam little or no money.
The tax results will be easier to understand if you are not married and live in the house alone. Your heirs will be able to sell the property and pay little to no federal tax.
In community property states , there are special step-up rules
Your spouse and you own your home in a community property state (Arizona. California. Idaho. Louisiana. New Mexico. Nevada. Washington. Wisconsin). The tax basis for the entire residence rises to FMV when your spouse dies. This applies not just to the 50% that was owned by the spouse who has since died. This strange but true rule allows the spouse who is surviving to sell the house within a few days of the death of the spouse and pay little or no tax to Uncle Sam.
To put it another way, even if you are the surviving spouse, the tax-saving benefits of the basis-step-up rule do not apply to you. There is no tax advantage to retaining the property if you choose to.
What is the reverse mortgage strategy?
You can see that holding on to a highly appreciated home until death can help you save tons of taxes due to the basis-up rule. We haven’t yet addressed the problem of cash flow if you are in dire need of money right now. The reverse mortgage strategy is available.
A reverse mortgage doesn’t require you to make any payments to the lender unless you move out or die. The property can then be sold and the reverse mortgage balance will be paid out of the proceeds. Any proceeds remaining go to you and your estate. Your heirs may choose to keep your home rather than sell it. They must then pay off the remaining funds with another source.
Your heirs may also choose to pay off the reverse mortgage and retain the property with the basis step-up. A HECM will ensure that your heirs never have to pay more the loan balance, or 95% of the appraised value of the home, whichever is lower. Nice.
What fees are associated with a reverse mortgage?
Reverse mortgage fees are usually more expensive than regular home equity loans or lines of credit. A HECM will typically charge an origination fee of 2% on the first $200,000 of the home’s worth and 1% for any additional $200,000. The origination fee is not allowed to exceed $6,000.
A mortgage insurance premium (MIP), which is charged to you in order to lower the risk of losing your loan to the Department of Housing and Urban Development or the lender, will be added to your monthly payment. MIP includes an initial payment that is based on property value, and an annual renewal that is based upon the outstanding loan balance.
A small monthly service fee may also be charged by the lender. You will typically be required to pay third-party closing costs such as title insurance, appraisals, settlement services, etc. These fees are added to the original reverse mortgage balance and decrease your loan proceeds.
To find the right product for you, you will need to research.
Is it possible to deduct interest from a reverse mortgage that was used to release cash?
According to the federal income tax rules, no. The 2017 Tax Cuts and Jobs Act (TCJA) makes it non-deductible for home equity loans that include reverse mortgages.
It is possible to object to borrowing against your house to cover a cash shortfall. It’s fair enough. But the cash you need has to come from somewhere. The tax bill for getting the cash you need will be high if it comes from the sale of your home.
If you are able to get the cash you need through a reverse mortgage, then the only costs will be the interest and fees. The reverse mortgage strategy is a good option if you can avoid only a fraction of the taxes by keeping your home.