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Essential Insights into Reverse Mortgages

Reverse mortgages stand as a unique financial instrument, primarily for homeowners aged 62 and older, enabling them to tap into their home equity and convert it into cash. Contrasting typical mortgage setups, where the borrower contributes payments to the lender, reverse mortgages inversely channel payments from the lender back to the homeowner, delivered as a lump sum, periodic payments, or a flexible line of credit.

Reverse mortgages necessitate a first trust deed, implicating that any pre-existing loans must be settled independently or through the gained reverse mortgage funds. The borrowing potential correlates with the borrower's age—the older the individual, the higher the potential loan amount and the more favorable the interest rate. These arrangements are intricately governed by the current debt profile of the borrower.

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Upon settling a reverse mortgage, there is an accumulated interest that must be settled alongside the principal balance—and in certain circumstances, this interest might be tax-deductible. Here’s a detailed examination of the tax and financial ramifications associated with reverse mortgages:

Financial Proceeds

  • Tax Implications: Proceeds received from a reverse mortgage are classified by the IRS as loan proceeds, not taxable income, regardless of how they are disbursed—whether a lump sum, a line of credit, or periodic payments.

  • Social Security & Medicare Compliance: Given that reverse mortgage proceeds are not deemed income, they do not interfere with Social Security, Medicare benefits, or associated tax provisions.

Interest Deduction Nuances

  • Interest Deductibility: Interest on reverse mortgages is deductible only upon full repayment, typically coinciding with the home's sale or the borrower's passing. This deduction is flagged on Form 1098, which the lender provides when the mortgage is resolved.

  • Loan Purpose Criteria: The IRS generally limits this deduction to scenarios where funds are utilized to "buy, build, or substantially improve" the home (according to IRC Section 163(h)(3)). As most reverse mortgage recipients allocate these funds to living expenses, deduction opportunities are often curtailed.

  • Assessing Equity Debt Interest: Since 2017, equity debt interest has been non-deductible. However, if refinancing home acquisition debt, a pro-rated portion of the interest can be deducted accordingly.

  • Deduction Claims: The responsible party settling the loan can claim deductible accrued interest, contingent on equity interest inclusion. Options include the borrower (if living in the home), the estate (upon borrower’s death), or heirs (if they pay off the mortgage post-inheritance).

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Means-Tested Benefits & Risks

  • Medicaid & SSI Considerations: Reverse mortgage proceeds constitute assets. Holding significant sums of unspent cash might disqualify individuals from means-tested benefits like Medicaid or SSI. It’s advisable to deplete these funds within the same month of receipt to circumvent eligibility issues.

Homeowner Obligations

  • Property levies & Insurance Commitments: Borrowers remain responsible for adhering to property tax payments and maintaining insurance and property upkeep. Delinquencies in these areas can precipitate foreclosure risks.

  • Financial Appraisal: Lenders require a financial evaluation pre-loan disbursement to assure ongoing expense management. Historical late payments may necessitate a portion of proceeds be allocated into a Life Expectancy Set-Aside (LESA) to cover these obligations.

Considerations for Heirs

  • Non-Recourse Assurance: Many reverse mortgages, notably FHA-insured Home Equity Conversion Mortgages (HECMs), are protected as non-recourse loans, guaranteeing heirs will not inherit debt surpassing the home value. If the mortgage exceeds the home's market value, FHA insurance bridges the gap.

  • 95% Acquisition Stipulation: Under this rule, should heirs opt to acquire the home, they can do so at 95% of its appraised value or the outstanding loan balance, whichever is lower.

  • Standard Capital Gains Framework: Heirs benefit from a "stepped-up" basis upon inheriting a home with a reverse mortgage, potentially reducing or eliminating capital gains tax should they sell the property shortly thereafter.

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Reverse Mortgage Downsides

Despite their flexibility, reverse mortgages carry inherent drawbacks. The compounding interest increases the remaining balance, thus impacting the available equity for borrowers and their inheritors. Additionally, associated fees and closing costs often surpass those of traditional mortgages. For individuals anticipating relocation, reverse mortgages may pose financial misalignment, emphasizing the importance of weighing their pros and cons comprehensively.

Should you have inquiries or require assistance with reverse mortgages, feel free to contact our office.

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If any of these topics caught your attention, please contact to start the conversation!
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