Tax implications of reverse mortgages
A reverse mortgage is a type of home equity loan that allows certain homeowners to convert their home equity into cash.
Because it is a type of mortgage, it offers some of the same tax advantages as conventional mortgages. At the same time, the unique nature of reverse mortgages means there are limitations to how much of your interest expense you can deduct.
Is a reverse mortgage taxable?
Any proceeds you receive from a reverse mortgage will not be taxed by the IRS. Because reverse mortgage payments are considered part of a loan that you will have to repay, they are not income.
Also, because a reverse mortgage is not taxable income, the money generated from the loan will not impact the formula the IRS uses to determine whether to tax your Social Security benefits.
Currently, if you are a single filer with an adjusted gross income between $25,000 and $34,000 (or between $32,000 and $44,000 for joint filers), then half of your Social Security benefits may be taxable. If your AGI exceeded those limits, then up to 85 percent of your Social Security benefits are taxable.
Your reverse mortgage income will not count in your AGI calculation, so it has no impact on Social Security taxation. Furthermore, if you use reverse mortgage proceeds in lieu of other income sources, such as withdrawals from a retirement income, then you might be able to minimize your tax bill if you can therefore reduce your AGI below $25,000 (or $32,000 for joint filers).
Is there a reverse mortgage interest deduction?
In addition to not paying taxes on your reverse mortgage, the interest you pay on the loan can be tax deductible, just like it is with conventional mortgages. But there are a few catches.
First, by IRS rule you cannot deduct mortgage interest until you actually pay it. For reverse mortgages, this doesn’t usually occur until you repay the entire loan, which is usually when you move out of the home or when you pass away. Before the closing of the loan, the interest accrues over time.
So if the borrower moves from the home and then has to pay off the reverse mortgage, the accrued interest may be tax deductible. If it’s a situation where the borrower dies, the interest paid on the loan after it’s settled is deductible on the estate’s tax returns.
The only other way to deduct reverse mortgage interest is to make payments before the loan becoming due.
Keep in mind that pre-payments may be applied to certain parts of the reverse mortgage balance in a specific order. At any time, your loan balance will include principal, interest, mortgage insurance premiums, and monthly service fees.
Therefore, your entire payment won’t necessarily be applied to paying off interest. When you make a payment, the lender will issue you a 1098 statement showing the amount of interest and other costs you can deduct from that year’s tax filing.
The other catch is that the IRS typically treats a reverse mortgage the same as a home equity loan, which limits how much of the interest you can deduct.
According to the IRS, you can only deduct interest on up to $100,000 principal of a home equity debt, including a reverse mortgage. Interest on any proceeds that you receive(d) more than that threshold cannot be deducted.
That $100,000 limit is NOT the amount of interest you can deduct. It’s a limit on the amount of principal you borrowed for which you can deduct interest. In essence, if when you repay your reverse mortgage, your principal balance is $200,000, you will only be able to get a tax deduction on roughly half the interest that accrued.
The IRS does allow immediate deductions for fees and costs of originating the loan, such as broker fees, document fees and “points” you paid in exchange for a lower interest rate. Origination costs can be deducted using Schedule A, provided you itemize deductions.