Sunday, May 15, 2011

Reverse Mortgages - Estate Planning and Income Taxes

A reverse mortgage is a loan program in which the homeowner receives payments from the lender rather than making payments on a loan.

To qualify, you must be at least 62 years old and own your home free and clear, or have a very small loan balance relative to the value of your home. A formula is used to calculate the amount of money that can be loaned against your home based on your life expectancy and the amount of equity in your home.

The older you are and the more equity you have, the larger the loan amount. The idea of the reverse mortgage program is to give senior citizens money to live on without being forced to sell their home when their equity runs out.

Homeowners can receive money from the reverse mortgage in monthly payments, or, if they prefer, they can get a lump sum of cash.

The monthly cash payments (or lump sum) that you receive from a reverse mortgage are not taxable income because you (or your heirs) have to pay the money back when the home is sold. It is just like any other kind of loan. Borrowed money is not "income" because it is a debt obligation that has to be repaid.

Now, let's look at how a reverse mortgage affects your interest deduction. We all know that the interest paid on your home mortgage is tax deductible each year. It is the last great tax shelter available to the average American.

But what happens when you don't pay your mortgage interest each year, as is the case with a reverse mortgage?

You don't lose the interest deduction, you merely have to wait until the interest is actually paid before you can claim it.

For example, if a homeowner had accumulated $60,000 worth of unpaid interest on his reverse mortgage and decided to sell his house, he could claim a $60,000 mortgage interest deduction for the tax year in which the home sale closed.

Some homeowners use this feature of reverse mortgages as an estate planning tool. Financial planners sometimes use reverse mortgages to reduce the estate tax burden on their clients.

Even though no payments are required on a reverse mortgage, financial planners sometimes have their clients pay down some or all of the accumulated interest in tax years when it is advantageous for them to do so.

In some cases, an estate planner will have his clients take out a reverse mortgage and use the proceeds to buy a single payment "last-to-die" insurance policy that would pay off the reverse mortgage. The money left over would then be given to the heirs.

When the estate is settled, the tax-free insurance proceeds would pay off the reverse mortgage principal, and the accrued mortgage interest will be used to offset estate taxes. So, in essence, the estate planner has moved money from the taxable pile to the nontaxable pile by acquiring a reverse mortgage at no cost to his client and providing some cash up front for a gift to the children or other heirs.

As you can see, the tax consequences of a reverse mortgage can get a little complicated if you are using sophisticated estate planning strategies, so please consult a professional tax adviser before making any final decisions.

If you are just using a reverse mortgage to generate cash to live on until you pass on, however, you won't have to worry about the income tax consequences. The unpaid interest will be deducted from the sale or refinance of your home by your heirs.