De­duct­ing in Re­verse

Re­verse mort­gages present a num­ber of ap­peal­ing fea­tures for bor­row­ers — and a num­ber of con­found­ing tax im­pli­ca­tions.

Financial Planning - - CONTENT - By Michael Kitces

Re­verse mort­gages present a num­ber of ap­peal­ing fea­tures for bor­row­ers — and a num­ber of con­found­ing tax im­pli­ca­tions.

THE AP­PEAL OF A RE­VERSE MORT­GAGE IS THAT it al­lows home­own­ers to bor­row against their pri­mary res­i­dence’s value with­out mak­ing on­go­ing pay­ments. In­ter­est sim­ply ac­crues on top of the prin­ci­pal and most com­monly is not re­paid un­til ei­ther the home­owner moves and sells the home, or it is sold by heirs af­ter the owner dies.

How­ever, bor­row­ers (and their ad­vis­ers) of­ten over­look the tax im­pli­ca­tions of re­verse mort­gages. If not planned for, sub­se­quent mort­gage in­ter­est tax de­duc­tions may be lost for the bor­rower or his or her heirs. Con­se­quently, it’s es­sen­tial to co­or­di­nate a re­verse mort­gage with the rest of a client’s tax- and es­tate-plan­ning strate­gies.


The only re­verse mort­gage in­sured by the fed­eral gov­ern­ment is called a Home Eq­uity Con­ver­sion Mort­gage and is avail­able only through an Fha-ap­proved lender. One of the most pop­u­lar sell­ing points of an HECM is that the money re­ceived is tax-free.

This is be­cause a re­verse mort­gage is noth­ing more than a loan against an ex­ist­ing as­set — re­gard­less of whether the re­verse mort­gage is an up­front lump sum, a line of credit that’s pe­ri­od­i­cally drawn against or struc­tured as ten­ure pay­ments for life.

It is no more tax­able as in­come than a loan to buy a car or pay for col­lege, a home eq­uity line of credit or a loan against a life in­sur­ance pol­icy.

While it might be called in­come for house­hold cash flow pur­poses, it’s re­ally just a loan — al­beit one sub­ject to spe­cial terms and bor­row­ing re­quire­ments.


De­ter­min­ing the deductibility of re­verse mort­gage in­ter­est is far more com­plex, how­ever.

The stan­dard rules un­der IRC Sec­tion 163(h) state that per­sonal in­ter­est is not tax-de­ductible. But there is an ex­cep­tion un­der IRC Sec­tion 163(h)(3) that al­lows a de­duc­tion for pay­ments of “qual­i­fied res­i­dence in­ter­est” — that is, mort­gage in­ter­est that is clas­si­fied as ei­ther “ac­qui­si­tion in­debt­ed­ness” or “home eq­uity in­debt­ed­ness.”

Ac­qui­si­tion in­debt­ed­ness is a mort­gage debt in­curred to ac­quire, build or sub­stan­tially im­prove ei­ther a pri­mary res­i­dence or a de­signed sec­ond home. Home eq­uity in­debt­ed­ness de­scribes any mort­gage debt against a pri­mary resi-

dence or sec­ond home that doesn’t qual­ify as ac­qui­si­tion in­debt­ed­ness.

The clas­si­fi­ca­tions of mort­gage debt are sig­nif­i­cant. In­ter­est on the first $1 mil­lion of ac­qui­si­tion debt prin­ci­pal is de­ductible, but tax­pay­ers can deduct the in­ter­est on only the first $100,000 of home eq­uity in­debt­ed­ness. Ad­di­tion­ally, in­ter­est on home eq­uity in­debt­ed­ness is an al­ter­na­tive-min­i­mum -tax ad­just­ment, which means the de­duc­tion is lost en­tirely for those al­ready pay­ing AMT.


Notably, the rules clas­si­fy­ing mort­gage debt are based not on what the lender calls the mort­gage, but how the loan pro­ceeds are used. Thus, a home eq­uity line of credit to ex­pand the home is ac­qui­si­tion debt, but a cash-out re­fi­nanc­ing of a 30-year mort­gage that is used to con­sol­i­date and re­pay credit card debt is home eq­uity in­debt­ed­ness — at least for the ad­di­tional cash-out por­tion of the loan.

Mean­while, a mort­gage taken out when a pri­mary res­i­dence is pur­chased is ac­qui­si­tion debt. But if the owner buys the prop­erty with cash and later does a cash-out re­fi­nance for the same mort­gage amount and terms, he or she will have the in­ter­est treated as home eq­uity in­debt­ed­ness be­cause the loan pro­ceeds weren’t used to ac­quire the res­i­dence.

Fur­ther­more, un­der Trea­sury Reg­u­la­tion 1.163-10T(c)(1), mort­gage in­ter­est deductibility is fur­ther lim­ited to a debt bal­ance that doesn’t ex­ceed the orig­i­nal pur­chase price of the home. Thus, if the orig­i­nal pur­chase price was $300,000 and a home ex­pan­sion in­creased the ad­justed pur­chase price to $350,000, the owner can never deduct mort­gage in­ter­est on more than $350,000 of mort­gage debt. In most typ­i­cal tra­di­tional mort­gage sit­u­a­tions, this is a non-is­sue, as the mort­gage would typ­i­cally start at $300,000 or less and amor­tize down­ward.

Is­sues arise if the house ap­pre­ci­ates and a sub­se­quent cash-out re­fi­nance in­creases the mort­gage bal­ance above the orig­i­nal pur­chase price, plus im­prove­ments. And it can also be a lim­it­ing fac­tor for neg­a­tive amor­ti­za­tion loans, where the in­ter­est com­pounds against the loan bal­ance over time.

A re­verse mort­gage is still in­debt­ed­ness against a pri­mary res­i­dence, which means the same rules ap­ply to deduct re­verse mort­gage in­ter­est. This in­cludes the de­ter­mi­na­tion of whether the loan bal­ance will be clas­si­fied as ac­qui­si­tion debt or home eq­uity in­debt­ed­ness. How­ever, there’s an im­por­tant caveat: Un­der IRC Sec­tion 163(h), mort­gage in­ter­est is de­ductible only when it’s ac­tu­ally paid.

That’s a big deal for a re­verse mort­gage, be­cause the bor­rower is typ­i­cally not mak­ing any in­ter­est (or other) pay­ments on an on­go­ing ba­sis. Yet if the mort­gage merely ac­crues and com­pounds, there can be no in­ter­est de­duc­tion on a year-by-year ba­sis.

In­stead, the cu­mu­la­tive loan in­ter­est is of­ten re­paid when the re­verse mort­gage fi­nally ter­mi­nates.


The prob­lem with the typ­i­cal lump-sum re­pay­ment of a re­verse mort­gage is that when the cu­mu­la­tive loan in­ter­est is re­paid all at once — and thus claimed as a de­duc­tion all at once — the ac­crued debt might ex­ceed the ad­justed pur­chase price of the prop­erty.

Fur­ther­more, if the tax­payer does not have enough in­come to be off­set in that par­tic­u­lar tax year, much of the de­duc­tion could be lost en­tirely.

In their Jour­nal of Tax­a­tion ar­ti­cle “Re­cov­er­ing a Lost De­duc­tion,” Stephen R. Sacks, et al., ex­plore how to avoid los­ing the tax ben­e­fits of the re­verse mort­gage in­ter­est de­duc­tion in lump-sum re­pay­ment sce­nar­ios.

The most straight­for­ward is, in the tax year the re­verse mort­gage will be re­paid, the owner should cre­ate tax­able in­come that can then be ab­sorbed by the mort­gage in­ter­est de­duc­tion. This might be ac­com­plished with an IRA dis­tri­bu­tion or a par­tial Roth con­ver­sion or sim­ply by en­sur­ing the owner’s to­tal in­come from other sources is suf­fi­cient to fully off­set the avail­able de­duc­tion.

If the pri­mary res­i­dence has ap­pre­ci­ated such that there’s a cap­i­tal gain, even af­ter the up-to-$500,000 cap­i­tal gain ex­clu­sion for the sale of a pri­mary res­i­dence, the ex­cess gains can also po­ten­tially be off­set by the mort­gage in­ter­est de­duc­tion. And while

In the tax year the re­verse mort­gage will be re­paid, the owner should cre­ate tax­able in­come that can then be ab­sorbed by the mort­gage in­ter­est de­duc­tion.

the de­duc­tion is less valu­able when ap­plied against a cap­i­tal gain in­stead of or­di­nary in­come, it’s still bet­ter than be­ing lost al­to­gether for lack of suf­fi­cient in­come.

If the orig­i­nal home­owner dies, a ques­tion arises: Who gets to claim the in­ter­est? It is not the de­ceased home­owner any­more. In­stead, it is now a tax is­sue for the es­tate or heirs.

For­tu­nately, Trea­sury Reg­u­la­tion 1.691(b)-1 al­lows a dece­dent’s prospec­tive de­ductible items not paid at death to be de­ducted when paid by ben­e­fi­cia­ries.

How­ever, in many cases, the ben­e­fi­cia­ries them­selves lack suf­fi­cient in­come to be off­set by the mort­gage in­ter­est, es­pe­cially when most as­sets get a step-up in ba­sis. The es­tate in­her­its the house to liq­ui­date, but doesn’t in­herit pre­tax re­tire­ment ac­counts that might have cre­ated tax­able in­come.

Ac­cord­ingly, one must con­sider who will in­herit a prop­erty sub­ject to a re­verse mort­gage that might be re­paid af­ter death, and whether he or she will have suf­fi­cient in­come to off­set or ab­sorb the avail­able de­duc­tion. Al­ter­na­tively, the bor­rower can avoid the po­ten­tial clus­ter­ing of the re­verse mort­gage’s in­ter­est de­duc­tion pay­ment at death by vol­un­tar­ily pay­ing the in­ter­est an­nu­ally (though notably, pay­ments are first ap­plied against ac­crued mort­gage in­sur­ance pre­mi­ums and ag­gre­gate ser­vic­ing fees).

And such on­go­ing re­pay­ments might not be man­age­able, ei­ther, depend­ing on the re­tiree’s cash flow.


Mort­gage in­ter­est pay­ments are de­ductible only when the bor­rower ac­tu­ally item­izes de­duc­tions — which isn’t al­ways the case for re­tirees. It is even less likely if the stan­dard de­duc­tion is in­creased in 2017 and be­yond as pro­posed in Pres­i­dent Trump’s and the House Repub­li­cans’ tax re­form plans.

Thus, if the stan­dard de­duc­tion is high enough that item­ized de­duc­tions are in­di­rectly cur­tailed for many re­tirees, it might be more de­sir­able to sim­ply al­low the mort­gage in­ter­est to ac­crue — though, again, it’s still nec­es­sary to en­sure suf­fi­cient in­come in that liq­ui­da­tion/re­pay­ment year to ac­tu­ally ab­sorb the full de­duc­tion.

Aside from the po­ten­tial de­duc­tion for a re­verse mort­gage’s in­ter­est pay­ments, tax­pay­ers can also po­ten­tially deduct mort­gage in­sur­ance pre­mi­ums as mort­gage in­ter­est un­der IRC Sec­tion 163(h)(3)(e).

How­ever, to claim the MIP de­duc­tion, it’s nec­es­sary that the mort­gage it­self has been is­sued since Jan. 1, 2007, and that the re­verse mort­gage debt be clas­si­fied as ac­qui­si­tion in­debt­ed­ness and not home eq­uity in­debt­ed­ness. This means the deductibility of the MIP de­pends on how the pro­ceeds of the re­verse mort­gage are ac­tu­ally be­ing used. And the im­pact can be sub­stan­tial, given that re­verse mort­gages have both an up­front MIP of 0.5% to 2.5% and an on­go­ing MIP of 1.25%.

Again though, pay­ments — whether for mort­gage in­ter­est or mort­gage in­sur­ance pre­mi­ums — are de­ductible only when ac­tu­ally paid, mean­ing that when the up­front MIP is rolled into the re­verse mort­gage bal­ance and the an­nual MIP ac­crues on top, pay­ments haven’t been made and the MIP cost can’t be de­ducted.

In­stead, if the pay­ments aren’t made un­til the prop­erty is liq­ui­dated and the mort­gage is paid off in full, the MIP will be de­ductible at that time, all at once, and face the same thresh­old is­sue re­gard­ing suf­fi­cient in­come to ab­sorb the de­duc­tion.

The MIP deductibility sit­u­a­tion is fur­ther com­pli­cated by an in­come phase-out, which kicks in as in­come goes above $100,000 of ad­justed gross in­come (for both in­di­vid­u­als and mar­ried cou­ples fil­ing jointly), with a full phase-out above $109,000.

Thus, if the MIP de­duc­tion comes due all at once, from a big liq­ui­da­tion that trig­gers a big cap­i­tal gain, it may cre­ate in­come against which the de­duc­tion would be off­set — push­ing the tax­payer over the line where none of the MIP is de­ductible.

In prac­tice, these con­straints may prove moot, as the de­duc­tion for mort­gage in­sur­ance pre­mi­ums was ex­tended last un­der the PATH Act of 2015 through the end of 2016, and lapsed as of Dec. 31, 2016.

Of course, it may be re­in­stated later in 2017; it has al­ready been re­in­stated retroac­tively af­ter laps­ing more than once in the

Tax­pay­ers can also po­ten­tially deduct mort­gage in­sur­ance pre­mi­ums as mort­gage in­ter­est.

past decade. Al­ter­na­tively, it could be­come a mat­ter of per­ma­nent tax law un­der in­come tax re­form.

Still, as it stands now, MIP pay­ments aren’t even de­ductible in 2017, much less in a dis­tant fu­ture year when the prop­erty is fi­nally sold and the re­verse mort­gage is liq­ui­dated. And even if the de­duc­tion gets re­in­stated and sticks around, it may be a has­sle to cal­cu­late how much of the (cu­mu­la­tive) pay­ments are de­ductible, as un­for­tu­nately the rel­a­tive bal­ances of mort­gage in­sur­ance pre­mi­ums, in­ter­est and prin­ci­pal are not di­rectly tracked in the cur­rent Form 1098 re­port­ing from the lender. At best, bal­ances would have to be de­ter­mined, or re­con­structed ret­ro­spec­tively, from monthly re­verse mort­gage state­ments.


One fi­nal point of com­plex­ity with a re­verse mort­gage is how to han­dle real es­tate taxes.

In gen­eral, the deductibility fol­lows the nor­mal rules un­der IRC Sec­tion 164: The taxes are de­ductible when ac­tu­ally paid. Thus, reg­u­lar pay­ments for real es­tate taxes through a mort­gage ser­vicer — as part of the full PITI monthly pay­ment — are still de­ductible be­cause they were ac­tu­ally paid, even if through the ser­vicer’s es­crow ar­range­ment. And a di­rect pay­ment of real es­tate taxes is also de­ductible when paid.

The fa­vor­able treat­ment stands when us­ing a re­verse mort­gage to gen­er­ate cash to make a real es­tate tax pay­ment — whether by draw­ing against the home eq­uity line of credit, us­ing the lump-sum pro­ceeds of a cash-out re­verse mort­gage, or via the on­go­ing ten­ure pay­ments struc­ture. From the tax code’s per­spec­tive, it’s ir­rel­e­vant how the tax­payer got the money; all that mat­ters is that the pay­ment oc­curred and a real es­tate tax obli­ga­tion was paid.

The sit­u­a­tion is some­what more am­bigu­ous for real es­tate taxes paid di­rectly from the HECM re­verse mort­gage, which can hap­pen when tax­pay­ers fail to meet un­der­writ­ing re­quire­ments and have a Life Ex­pectancy Set Aside.

The LESA rules are in­tended to en­sure that re­verse mort­gage bor­row­ers don’t un­wit­tingly de­fault on the loan by fail­ing to make prop­erty tax and home­owner’s in­sur­ance pay­ments. In­stead, those amounts are drawn di­rectly from the mort­gage and are then held in es­crow. Pay­ments for taxes and in­sur­ance are then re­mit­ted.

The LESA rules en­sure that the bor­rower doesn’t max out the re­verse mort­gage bor­row­ing limit for other pur­poses and then leave him­self un­able to pay prop­erty taxes (and home­owner’s in­sur­ance), which could trig­ger a de­fault.

In­stead, the re­verse mort­gage bor­row­ing ca­pac­ity is carved out to pay the taxes and in­sur­ance, and the home­owner re­mains re­spon­si­ble for the rest of his bills — al­beit with­out prop­erty taxes and home­owner’s in­sur­ance loom­ing.

The prob­lem, though, is that in the LESA sce­nario, the tax­payer never ac­tu­ally makes a per­sonal pay­ment for prop­erty taxes, which raises ques­tions about its deductibility. Nonethe­less, some ar­gue that given the le­gal tax obli­ga­tion is sat­is­fied and the tax­payer in­curs an ac­tual debt — that is, an in­crease in the re­verse mort­gage bal­ance — it should still be con­struc­tively treated as a pay­ment for tax pur­poses at the time the prop­erty taxes are paid via the re­verse mort­gage, even if it wasn’t a per­sonal cash out­flow for the home­owner.

But there is no de­fin­i­tive tax guid­ance to clar­ify the treat­ment, or clearly dis­tin­guish why an in­crease in re­verse mort­gage debt bal­ance for in­ter­est is not de­ductible, while a sim­i­lar in­crease in the bal­ance for a pay­ment of real es­tate taxes might be de­ductible.

The bot­tom line: it’s im­por­tant to be aware of the po­ten­tial pit­falls on the tax deductibility as­so­ci­ated with re­verse mort­gages.

While the stan­dard rules for deductibility of mort­gage in­ter­est, in­sur­ance pre­mi­ums and real es­tate taxes re­main, a re­verse mort­gage ne­ces­si­tates more in-depth tax plan­ning and co­or­di­na­tion.

From the tax code’s per­spec­tive, it’s ir­rel­e­vant how the tax­payer got the money; all that mat­ters is the pay­ment.

Michael Kitces, CFP, a Fi­nan­cial Plan­ning con­tribut­ing writer, is a part­ner and direc­tor of wealth man­age­ment at Pin­na­cle Ad­vi­sory Group in Columbia, Mary­land; co-founder of the XY Plan­ning Net­work; and pub­lisher of the plan­ning blog Nerd’s Eye View. Fol­low him on Twit­ter at @Michaelk­itces.

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