Reverse Mortgages and Irrevocable Trusts

How they work, and what happens if you combine them

A reverse mortgage allows you access to a portion of your home equity while you’re still living in the home. If you put that home into an irrevocable trust, you may be able to avoid estate taxes when you die and qualify more easily for Medicaid benefits if you ever need to go into a nursing home.

Let’s take a look at how reverse mortgages and irrevocable trusts work and what happens when the two are combined.

Key Takeaways

  • Reverse mortgages allow people ages 62 and older to tap a portion of their home equity without selling the home.
  • Irrevocable trusts are a way to shield assets—including a home—from estate taxes. They also can make it easier to qualify for Medicaid benefits.
  • Both reverse mortgages and irrevocable trusts can be costly and have other downsides.
  • A home with a reverse mortgage can be held in an irrevocable trust, although that is unlikely to be beneficial for most people.

How a Reverse Mortgage Works

A reverse mortgage lets a homeowner extract equity from their home in a variety of ways, including a lump sum, monthly income, or a line of credit to draw on as needed. The loan has to be paid back after the borrower dies, move outs, or sells the home. 

The most common type of reverse mortgage is a home equity conversion mortgage (HECM), for which the borrower and any co-borrower must be at least age 62. The loan is insured by the Federal Housing Administration (FHA) to protect the lender. Younger spouses can be listed on the loan as an eligible non-borrowing spouse, which gives them a right to remain in the home after their spouse dies or moves out (such as into a nursing home), if they meet certain other requirements.

HECMs are issued only by FHA-approved lenders. The maximum loan amount is $970,800. Some lenders also offer proprietary reverse mortgages, which are not insured by the government but can have higher lending limits.

How an Irrevocable Trust Works

Trusts can be either revocable or irrevocable. With the former, you can change the terms at any time. With the latter, the terms are much harder to change.

Both types of trusts can give you more control than a last will and testament does over how your assets are handled after your death (or sometimes during your life). Both can also allow assets, such as your home, to bypass the often slow and costly probate process. In general, trusts are harder for disappointed heirs to challenge successfully.

An irrevocable trust, as the name implies, locks in the decisions that you make when you first create it. For example, changing beneficiaries can be very difficult. The assets that you place in it become the property of the trust and are beyond your reach. This means that they are not counted in determining your estate tax liability or your eligibility for Medicaid (if you satisfy other rules, as described below) and are shielded from creditors.

Irrevocable trusts are generally more expensive to set up and maintain than revocable ones. They can take a variety of forms depending on what the grantor (the person establishing the trust) wants to accomplish.

Using an Irrevocable Trust to Avoid Estate Taxes

Because they remove assets from the grantor’s estate, irrevocable trusts can be used to avoid (or reduce) estate taxes. However, this will be of benefit only to people with fairly substantial estates. In 2022, the first $12,060,000 of assets are exempt from federal estate taxes.

Seventeen states and the District of Columbia also impose estate taxes and also exempt assets up to a certain level, with all exempting at least $2 to $5 million. According to the Center on Budget and Policy Priorities, fewer than 3% of estates on average owe state estate taxes.

$2–$5 million

The value of assets that 17 states plus the District of Columbia exempt from their state estate taxes.

Using an Irrevocable Trust to Qualify for Medicaid

Medicaid is a joint state and federal program that provides health insurance coverage to many low-income Americans, as well as those who are aged, blind, or have disabilities. The program’s rules can vary from state to state.  

People who might never have qualified for Medicaid coverage when they were younger often turn to it to pay for nursing home care or other long-term care services late in life. Medicare, the federal health insurance program for Americans ages 65 and older, only provides such coverage in very limited circumstances.

To be eligible for Medicaid coverage, a person must qualify on the basis of medical need and satisfy certain income and asset requirements. One of those assets is their home equity, although it is exempt up to a certain limit. With the exception of California, the limit in most states today for single individuals applying for Medicaid is either $636,000 or $955,000, according to the American Council on Aging. California doesn’t set a limit.

If the Medicaid applicant is married, there is no home equity limit as long as the other spouse is living in the home. In addition to any home equity that’s over the exemption limit, countable assets can include bank accounts, investments, retirement accounts, and second homes.

Spending down and the look-back period

People whose assets exceed the limits often use a tactic called a “spend down,” in which they spend assets to get under the limits. Spend downs are subject to a look-back period (five years in most states) during which the Medicaid applicant can’t have simply given away assets or sold them for less than fair market value—such as selling a home at a steep discount to another family member.

The list of big-ticket items that are allowed during the look-back period is relatively limited and includes things such as home modifications, car repairs, and medical devices that aren’t covered by insurance. The applicant can also pay for nursing home care out of their own pocket until they spend down enough to become eligible for Medicaid to take over.

Another way to reduce countable assets is to put them into an irrevocable trust. To qualify, however, the trust must be set up before the beginning of the look-back period.

There are also several exceptions that let a Medicaid applicant transfer their home to a relative during the look-back period. They include the caregiver-child exception, which allows for transferring the home to a child who has served as the applicant’s primary caregiver for at least two years and also lived in the home. Another is the sibling exception, for siblings who are part owner(s) of the home and have lived there for at least a year.

When Homes with Reverse Mortgages Are Held in Irrevocable Trusts

Irrevocable trusts and reverse mortgages serve different needs and typically appeal to different kinds of people. Irrevocable trusts are of the greatest use to people with significant assets that they wish to preserve and pass on to their heirs. Reverse mortgages tend to benefit people who may have no assets to speak of other than their home, which may not be of enormous value. The median loan amount for an HECM in 2018 was about $134,000.

Given the relatively large home equity exemptions for Medicaid, along with the similarly large exemptions for federal and state estate taxes, few reverse mortgage borrowers are likely to find that an irrevocable trust will be of much benefit. Rather than a trust, a homeowner with equity that’s over the limits could conceivably use a reverse mortgage to reduce that equity, but they would need to consider the cost of the reverse mortgage and the effect of adding the mortgage proceeds to their other assets.

Still, it is possible to put a home with a reverse mortgage into an irrevocable trust, and some beneficiaries of irrevocable trusts eventually will find themselves inheriting one. In such a case, the beneficiary will still need to pay off the reverse mortgage, either by selling the home or purchasing it themselves. If they’re fortunate, the trust will provide them with the funds to do that.

How much does an irrevocable trust cost?

The cost of setting up an irrevocable trust will vary by type, the complexity of the estate, the U.S. state in which it is created, and other factors. In most instances, it will be at least $3,000. One New York law firm put the average price at $6,000. In addition, there will be ongoing administrative costs that are likely to be in the hundreds or thousands of dollars annually.

What happens if you want to change an irrevocable trust?

Irrevocable trusts are difficult—but not impossible—to change. One technique that has become more common in recent years is known as “decanting.” In states where this is permitted, the trustee “pours” assets from the existing irrevocable trust into a new one with different terms.

Are reverse mortgage payments considered taxable income?

No. The Internal Revenue Service (IRS) considers the money that a homeowner receives from a reverse mortgage to be loan proceeds rather than income, and loan proceeds are not taxable.

The Bottom Line

Reverse mortgages and irrevocable trusts can be useful tools for financial and estate planning in some instances. However, they are both complicated and potentially expensive and aren’t right for everyone.

If either an irrevocable trust or a reverse mortgage is of interest to you, you’ll want to consult with a knowledgeable expert, such as an estate planning attorney, an accountant, or a financial planner, before proceeding. In the case of HECM reverse mortgages, the government also requires that you meet with an approved housing counselor.

Article Sources

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