If you’re thinking about taking out a reverse mortgage, you need to know whether and how it will affect your income tax situation. In this article we’ll explain whether reverse mortgage proceeds are taxable, whether the interest on a reverse mortgage is tax deductible and more.
The money you receive when you take out a reverse mortgage is not taxable – that’s the official word from the Internal Revenue Service, which classifies the payments as loan proceeds, not income. A reverse mortgage is, indeed, a loan, though many people don’t realize this. If you’ve ever gotten a loan to buy a car, you know that you didn’t pay taxes when the car dealership advanced you that money. You repaid it in monthly installments over five years, probably using income you earned from your job for which you’d already paid income tax.
Here’s another way of looking at why it doesn’t make sense for reverse mortgage proceeds to be taxable. With a reverse mortgage, the lender is essentially returning your home equity to you. How did you accumulate that equity? By making your monthly mortgage payments. And, as with the auto-loan example, you made those monthly mortgage payments out of your income – income on which you’d already paid taxes.
A reverse mortgage essentially gives you money that’s already yours by converting equity into cash. You don’t send the IRS a check when you make a withdrawal from your savings account, and you also don’t owe the IRS anything when you unlock the equity you’ve accumulated in your home through a reverse mortgage.
Because the lender is giving you money for a house that you still own, you’re basically getting a loan, and when you take out a loan, you usually have to pay interest. Unfortunately, reverse mortgages don’t have promotions like car dealerships or furniture stores where you can get 0% financing.
The interest rate on a reverse mortgage is either fixed, if you get the proceeds as a lump sum, or variable, if you get the proceeds as a stream of monthly payments or through a line of credit. Either way, the interest isn’t due until the loan is due, which can happen in one of several ways:
(For more, see Reverse Mortgage Pitfalls.)
How does the interest get paid when the loan is due? It is paid the same way the principal is repaid: through selling the home, refinancing the home or from personal assets. These are the three ways a reverse mortgage can be repaid in full. After it’s paid off, either you (if you’re still alive) or your heirs (if you’re deceased) may be able to take a tax deduction for the interest paid on the reverse mortgage. How much will depend on whether the mortgage was established by the end of 2017 or afterwards. The 2017 tax bill limits the amount of interest you can deduct to that on a $750,000 loan for new mortgages; previous mortgages can deduct interest on loans of $1 million or less.
With a forward mortgage, the kind you have when you’re paying off your house, you make monthly payments of principal and interest, and you can deduct the interest on your tax return each year. With a reverse mortgage, you don’t actually pay any interest until the loan is due, so a mortgage-interest tax deduction only exists in that one tax year. There is an exception, however: In rare circumstances, borrowers will make payments on their reverse-mortgage loans while they’re still living in the home, and in this case you can deduct the interest in the year you pay it.
As you might know, mortgage interest is only tax deductible if you itemize your deductions, and it only makes sense to itemize your deductions if they exceed the standard deduction. Because all of a reverse mortgage’s accrued interest is paid in the same year, there’s a chance it will exceed the standard deduction. However, as the standard deduction has been practically doubled for 2018 and beyond by the recent tax reform bill, that chance is considerably slimmer than it was before. The original borrower, the estate or the heir(s) also need enough income to be able to take advantage of the deduction, which can be another issue.
The IRS may limit your deduction, however, because there’s another key difference between deducting mortgage interest on a forward mortgage vs. a reverse mortgage. The IRS considers forward-mortgage interest to be interest paid on “acquisition debt.” Acquisition debt is mortgage debt used to purchase, build or substantially renovate a primary or secondary residence. You can deduct interest on as much as $750,000 in new acquisition debt (before the new tax law, that amount was $1 million).
However, the IRS may consider reverse-mortgage interest to be for “equity debt.” It depends on how the borrower used the loan proceeds, and this is where things get tricky and a tax professional’s advice can really help. Through the 2017 tax year, you can deduct interest on only $100,000 of equity debt – and from 2018–2025, there are no deductions for equity debt. So how a reverse mortgage loan is classified – acquisition or equity debt – makes a huge difference in which deductions may be available when the loan is repaid. In order for reverse debt to qualify as acquisition debt, it must have been obtained for home improvement or other “qualified purposes.” If you spent the money paying off medical bills, for example, it wouldn’t qualify.
In addition, the terms of a reverse mortgage require that you continue to pay property taxes for as long as you live in your home. Property taxes (which the IRS calls “real-estate taxes”) are deductible in the year you pay them. However, this tax deduction will only benefit you if you itemize, and without high amounts of mortgage interest – or medical and dental bills that exceed a certain percent of your adjusted gross income (7.5% for 2017 and 2018 and 10% for 2019 and beyond) – you will probably be better off taking the standard deduction, especially with it just having been nearly doubled.
Also, the new tax law has drastically limited itemized deductions for personal state and local property taxes and personal state and local income taxes, to a combined total of only $10,000 ($5,000 if filing singly or married filing separately). All that means you probably won’t be able to benefit from the property-tax deduction.
The proceeds you receive from a reverse mortgage – whether you get them as a lump sum, in monthly installments or through a line of credit – are not taxable. They’re considered a loan advance, not income. The interest you pay on a reverse mortgage may be tax deductible in the year you or your heirs terminate the mortgage and pay back the bank, depending on the details of your situation. (For more, see What Are the Different Types of Reverse Mortgages?)
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