Reverse Mortgages and Taxes

by Kent Kopen| May 30, 2017 | 2 Comments

Reverse Mortgage Tax Issues and StrategiesI'll Lose My Tax Deduction


If I get a reverse mortgage, I’ll lose my mortgage interest write-off.  We frequently hear that when we first meet clients.  It is a common misconception. 


What homeowners 62+ really need is clarity and direction around how and when interest on a reverse mortgage is tax deductible.


Prospective reverse mortgage borrowers, who have a conventional mortgage (the house is not paid off), also suffer from another common misconception; they don't realize the value of their current mortgage interest write-off.  Most people overestimate the value of that deduction.  We will cover that in more detail below.


There are several well-written academic research papers on tax implications with a home equity conversion mortgage (HECM – aka reverse mortgage).  Links to those papers are also included below.  The challenge for most of us is the length and complexity of academic writing.  I'm frequently asked for a summary of the basic concepts – but in plain English.


This article is not intended to be a substitute for, or to provide, tax advice.  We’re not qualified; besides, everyone’s situation is unique.  Rather, our objective is to answer the question: is reverse mortgage interest tax deductible.  To accomplish that, we'll familiarize you with terminology, present some example scenarios (from common to complicated), and provide an overview of reverse mortgage tax issues, opportunities, and strategies.


We want you to know enough to know when to get help from a professional.  Do you provide financial guidance to someone who has a reverse mortgage... maybe a parent?  Consider providing a copy of this article to your parent’s tax preparer, CPA, Enrolled Agent, or Trust Attorney before they sell their home or pass away because some strategies must be arranged beforehand to avoid paying unnecessary taxes.


This article is organized into four sections (click the blue number beside each heading to jump to that section)


  • Property-related Tax Deductions - I
    • Sale of home
    • Mortgage interest deduction
  • Value of a Mortgage Interest Deduction - II
  • Common Reverse Scenarios - III
    • Borrower passes away and heirs acquire house
    • Borrower sells and moves
    • Borrower pays down loan but stays in the house
  • Considerations at Different Income Levels - IV
    • Financial constrained
    • Underfunded
    • High net worth - mass affluent


Reverse Mortgages

Most people, including financial professionals, are not aware of all of the federal government’s recent changes to the FHA-insured Home Equity Conversion Mortgage program; i.e., reverse mortgages.


75 million members of the Baby Boomer generation will retire in the coming 15 years.  Partially funding retirement with home equity will become more common in the years ahead because the U.S. has a retirement savings deficit of nearly $6.8 trillion.  One-third of senior homeowners have enough equity to consider a reverse mortgage so they have better options.


There are currently close to 1 million reverse mortgage loans outstanding.  The value of those outstanding reverse mortgage-backed securities is nearly $55 billion.  With a million plus households having a reverse mortgage, and more to come, it is important that they, and their heirs, understand the tax issues and opportunities they face.



Tax Deductions for Owner Occupied Homes - I

There are two sections of the Internal Revenue Service tax code that affect most homeowners who have or are considering a reverse mortgage: Section 121, which covers taxes due when the home is sold; and Section 163, which covers the deductibility of mortgage interest paid.


IRC Section 121 – Exclusion of Gain from Sale of Principal Residence

This section covers profit when the home is sold for more than its purchase price plus home improvements.  This rule is sometimes referred to as the 250/500 rule because those are the limits of profit on which no taxes are due.


If you’ve owned and lived in a home for two of the five years before the sale, then, for single filers, up to $250,000 of profit is tax free.  And, for those who are married filing a joint return, $500,000 is tax free.  You only pay taxes on the profit from selling your home on the portion that is above the Section 121 threshold. Example one: a single filer who realizes $300,000 profit would pay taxes on ($300k - $250k) = $50k of profit.


Example two: a married couple buys a home in the early ‘80s for $200,000.  Over the years, they spend $50,000 in capital improvements (not repair expenses; see T.D 9564; REG-168745-03) making their adjusted cost basis $250,000.  Thirty years later they sell the home for $740,000 (net of commissions and fees).  They would not owe taxes because their profit ($750,000 - $250,000) = $490,000, which is under the $500k tax-free limit for a married couple filing jointly.


Many people do not know that they can sell an existing home and buy a new home with a reverse mortgage.  The advantage is they don’t use up all their sale proceeds when they buy the next house.


When downsizing with a reverse purchase (also known as a H4P or HECM for purchase) the borrower pays roughly half the purchase price in cash and uses a reverse mortgage for the difference.  This is handy for two reasons: 1) retirees may not have enough income to qualify for a conventional mortgage; and 2) it frees up some wealth that was trapped in the home.  This repositioned wealth can be used for other purposes and/or to rebuild a financial cushion for future expenses.


Back to the example two above: the seller had net proceeds of $490,000.  Perhaps the house they sold no longer fit – it was too big, the kids are gone, they don’t like the location, they need a downstairs bedroom, etc.  Now they’d like to buy a townhome for approximately $500,000.


Instead of using all their cash proceeds, they can implement the H4P strategy, put $250,000 down and use a reverse mortgage for the remainder.  Since they have $490,000 from the sale of their house, their downpayment is $250k, they use a reverse for the rest, and they still have $240,000 left over; ($490,000 - $250,000) = $240,000.  They may choose to have a financial advisor help them manage this new asset.


If there is profit above the 250/500 limit, it is taxable and is reported as a capital gain on Schedule D.  IRS Publication 523 – Selling Your Home includes a worksheet to figure you gain or loss on the sale of your home.  Long-term capital gains apply to any investment held for over one year.


The tax rate for long-term capital gains is based on income level and tax bracket:

  • Most pay 15%
  • Single filers with income over $112,500 pay 20%
  • Joint filers with income over $225,000 pay 20%

TurboTax has a great article that discusses other special circumstances like divorce, a spouse passing away, reduced exclusions, etc., that can affect the long-term capital gain exclusion.


The reason this gain on sale topic is relevant for an article on mortgage interest deductions is because a reverse mortgage is usually paid off when a home is sold.  Often, the borrower owned the home for many years and they realize a considerable profit. 


Capital gains above the 250/500 threshold can be partially offset with a large reverse mortgage interest deduction that occurs when the loan is paid off.


Oftentimes older homeowners don’t know about IRC 121; the 250/500 rule.  They think they must buy another house of equal or greater value within two years or sellers age 55 or older had a once-in-a-lifetime exemption of up to $125,000.  They're thinking of the old rules that changed with the Taxpayer Relief Act of 1997.  Now, there is no two-year requirement to buy a more expensive home, or any home at all.


This is fortunate, otherwise the HECM for purchase strategy wouldn’t work for seniors looking to downsize.  The Section 121 exclusion of gain on sale is available every time someone sells a primary residence that they’ve lived in for two of the five years leading up to the sale.


For those who sell and buy again, which is preferable to renting if possible; there is another way to reduce taxes but it concerns property taxes not income taxes.  That strategy is part of California Propositions 60 & 90 that address ways minimize property taxes by buying new home of equal or lesser value.



Mortgage Interest


When Mortgage Interest Is Tax Deductible

The whole point of a reverse mortgage is being able to access wealth without making a mortgage payment (principal & interest).  Reverse mortgages improve cashflow and provide cash reserves for unexpected or future expenses.


The mortgage interest that does not get paid each month (in constrast to a conventional mortgage) gets added to the loan balance.  That's known as negative amortization.  It isn’t a bad thing – it’s just how they work.


Understanding when reverse mortgage interest is deductible requires knowledge of the tax code and some terminology.  We start with how a loan is characterized, which determines the deductibility of accrued interest when it is paid.  Regardless of classification, mortgage interest that accrues is not deductible until it is paid.


Deductible mortgage interest falls into two categories:


  • IRC Section 163 – Acquisition Indebtedness – interest on loans taken out to buy or improve a house are considered Acquisition Indebtedness under IRS Code section 163(h)(3)(B)(i).
  • IRC Section 163 – Home Equity Indebtedness – interest on home loans taken out for any other purpose (like debt consolidation, travel, medical, etc.) – are defined as Home Equity Indebtedness under IRS Code section 163(h)(3)(C)(i).

Acquisition indebtedness is limited to $1 million of debt.  Purchase money interest on primary residence mortgage loans over $1 million is not deductible. 


Home equity indebtedness has a $100,000 limit for the mortgage interest to be deductible per IRC section 163(h)(3)(C)(ii).  Once a line of credit draw or home equity loan totals $100,000, IRC 163 says interest on loan amounts beyond that are not tax deductible.


With a reverse mortgage, because there are no principal and interest payments, the compounding nature of the loan creates a situation where interest accrues on interest.  The interest on interest on acquisition debt is considered Home Equity Indebtedness.  The IRS has not defined it as such, but that is the common conservative interpretation.


Home equity debt is doubly disadvantaged: it is limited to debt of only $100,000, (instead of $1 million like acquisition debt), and it is not deductible when computing AMT income.


Also note, when a borrower sells their home, a mortgage interest deduction cannot be carried back or forward, like a net operating loss.  It must be taken that year.



Maximizing a Reverse Mortgage Interest Deduction

A reverse mortgage has no principal or interest payment, but the homeowner must continue to pay their property taxes and hazard insurance separately.  The mortgage payments they don’t make are deferred resulting in interest accruing and compounding.


When the loan is repaid, accrued mortgage interest and mortgage insurance become deductible.  If the loan was in place for many years, the built-up interest and insurance can be sizable.  The amount of interest paid (deduction) may be more than the household’s income that year.


The liquidating homeowner (or heir) may need to plan to create income in the year the reverse mortgage is paid off to ensure there is enough income to be offset by the deduction.  Otherwise, the benefit of the mortgage interest deduction is lost.*



Creating Taxable Income

If the borrower’s income, including the capital gain in excess of Section 121 limits, is not enough to offset the interest deduction, and the borrower has an IRA or 401(k) account; it may be beneficial to draw from the IRA or 401(k) account whatever amount can be offset using any available interest deduction from the repayment of the reverse mortgage.  Or, the borrower might use the interest deduction to offset the tax on a Roth conversion of some or all of an IRA or 401(k) account.*




Regarding AMT, interest on acquisition debt is deductible when computing the alternative minimum taxable income, but interest on home equity debt is not.



Debt Balance Limit

Another consideration, not widely known, is that mortgage interest deductibility is limited to a debt balance that does not exceed the home’s adjusted cost basis, which is comprised of the original purchase price and home improvements as noted in Treasury Regulation 1.163-10T(C)(1).



1098 Errors

Borrowers (or heirs) need to be aware of servicer reporting errors or they will not get the full value of the deduction when a reverse mortgage is paid off.  This happens because companies frequently transfer or sell servicing rights.  When they do, there are often errors in the data transfer and that can result in underreporting the amount of interest paid.


To protect yourself, look at the amount of interest reported in box 1.  You can easily approximate what that number should be by multiplying the outstanding balance, times the interest rate, times how many years since the reverse mortgage was taken out.  That is roughly how much interest should show up in box 1.


The formula looks like this: (loan balance x interest rate x number of years loan outstanding) = total interest paid.  This wouldn’t be the case if someone took at a reverse mortgage line of credit, didn’t use it for many years, and then started to draw on it.


Here is an example of an error experienced by one of our clients who sold her home in 2016.  She received a 1098 showing mortgage interest of $5,428.  However, she took out the reverse in 2010.  Using back-of-the-napkin math, we can calculate approximately how much interest she paid: ($200,000 x 5% x 5 years) = $50,000.


Her 1098 was wrong by $45,000.  Six weeks after writing to the servicer requesting a corrected 1098, she has still not heard back from them.  Hopefully, she will not have to involve the CFPB.  The point is, don’t assume the servicer’s numbers are correct on 1098s, and if they’re not, be diligent in your follow up.



Value of a Mortgage Interest Deduction - II


The second big myth we encounter is the homeowner's perceptions on the value of their mortgage interest deduction.  Most people don’t know, or they overestimate, how much their mortgage write-off (mortgage interest deduction) is worth.


Roughly 45% of homeowners who pay mortgage interest receive no benefit at all from a mortgage interest deduction.  Those that do receive a benefit receive less than they think. 


For this to make sense, one must understand the difference between a tax deduction and a tax credit.  Tax credits provide a dollar-for-dollar reduction in taxes owed.  But tax deductions (like mortgage interest) reduce the amount of income we pay taxes on.  A deduction is only fractionally as good as a credit.  The fraction depends on your marginal tax rate.


For example: if someone has $50,000 in income, and they have a $6,000 deduction, they pay taxes on ($50,000-$6,000) = $44,000.  To qualify for a tax deduction, they must itemize deductions.


People can only itemize deductions if their itemized deductions total more than the current standard deduction. In 2017 the standard deduction is $6,350 for singles, and $12,700 for married taxpayers filing joint returns.


Tax payers who do not have enough deductions to itemize get no benefit from paying interest on their mortgages.


To look up your tax bracket and calculate your effective tax rate, check out this interactive tax calculator.

  • A married couple with $40,000 of taxable income pays federal tax at a 12.7% effective rate.
  • A married couple with $80,000 in taxable income pays federal tax at a 14.5% effective rate


Example homeowner, $80k annual income, conventional mortgage:

  • A $350,000 mortgage, 4.5% interest rate, would pay $15,570 in interest
  • Value of mortgage interest deduction ($15,570 x 14.5%) = $2,260.
  • Value of standard deduction ($12,700 x 14.5%) = $1,842.
  • Value of losing the mortgage deduction ($2,260 - $1,842) = $418 or $35/month.


If someone had considerable itemized deductions from say property taxes, charitable contributions, and medical bills; refinancing a conventional mortgage with a reverse mortgage, and temporarily ‘losing’ the mortgage interest deduction, means they would effectively lose ($2,260/12) = $188 per month.  The deduction is not lost, it’s postponed.  That said, most people do not have considerable deductions for those three items.


The average charitable deduction for those with $50k - $75k in adjusted gross income (AGI) is $2,970.   And on medical deductions, seniors 65+ only get to deduct the out-of-pocket amount that exceeds 7.5% of their income.  


This explains why many people may not be able to itemize, or their itemized deductions total just over the standard deduction.  In their case, ‘losing’ the mortgage interest deduction represents a loss closer to $35 per month.


I’ve heard people say, “eliminating my existing mortgage payment improves my cash flow by $1,000 per month, but I’m losing my interest write-off.”  They think their write-off functions like a tax credit instead of a tax deduction.  Their real annual cash flow improvement is between ($1,000–$188) = $812 to ($1,000-$35) = $965.


The write-off is worth less than most people realize.  Nearly half of all homeowners get no benefit from the mortgage interest they pay. 


Those who are able to itemize often have significant charitable contributions and they live in counties with high property taxes like Orange County, San Francisco, or San Diego.  So those two components alone nearly equal the standard deduction making mortgage interest paid deductible.


Now let’s look at the three most common scenarios for those with a reverse mortgage.



Common Reverse Scenarios - III


Borrower Passes Away - Heirs Acquire House

Interest can only be deducted when it is paid.  The heir of the borrower can benefit from a mortgage interest deduction (Treasury Regulation 1.691(b)-1) but careful planning is necessary to ensure the interest deduction is not lost.


That may include transferring the home in-kind to the heir(s) – meaning title and liens are transferred as opposed to selling house and giving heirs the money.  Then the heirs can sell the home making it possible that they may be entitled to the deduction.


If the heir’s taxable income is less than the amount of the deduction available, and the heir is also the beneficiary of the decedent’s IRA or 401k account, the heir might be able to take a distribution from those accounts to match and offset the amount of the interest deduction. Otherwise, some or all the deduction would be lost.*


Or, if the heirs wanted to keep the home, the reverse mortgage debt could be refinanced with a conventional mortgage, and the refinancing would constitute the payment, which may entitle the heir to the deduction.


In all cases, heirs should review the IRS Form 1098, Mortgage Interest Statement, when it arrives to make sure the amount reported in box 1 is accurate.  It is easy for errors to go unnoticed because heirs often have many other details they’re trying to resolve.



Borrower Sells and Moves

When a borrower sells and moves, regardless of their reason, the reverse mortgage gets paid off, and that generates a large mortgage interest deduction.  Similar to the strategy noted above, if the seller does not have enough income to offset the large deduction, they can ‘generate’ income by taking a distribution from a qualified account (401k, 403b, IRA) or from converting a qualified account to a Roth IRA.*



Borrower Inherits Money - Pays Down Reverse

Sometimes a borrower will choose to pay down a reverse mortgage but stay in the home.  For example, a borrower inherits money that is not subject to income tax and they want to pay down the balance.  There is no penalty to prepay a reverse mortgage, however, the order of how the prepayment is allocated differs from a conventional mortgage.


With a normal mortgage, sometimes called a forward mortgage, there is no build-up of unpaid interest or mortgage insurance.  Therefore, prepayments either push out the next payment due date or they reduce the loan’s principal balance, dollar for dollar.  If someone gets a $50,000 inheritance, and they send it to the loan servicer on a conventional loan, with a note to apply it the payment to principal, their principal balance will go down by $50,000.


However, with a reverse mortgage, both interest and the annual FHA insurance premiums build up because there are no monthly mortgage payments.


Reverse mortgage prepayments are applied in the following order:

  1. Accumulated mortgage insurance premiums
  2. Accumulated interest
  3. Principal

The following chart, prepared by Michael Kitces, is an excellent representation of how interest, interest on interest, and the mortgage insurance premium (MIP) build up over time.


Kitces - How Reverse Mortgage Interest and MIP Accrue Over Time.jpg 

The deductibility of mortgage insurance premiums is fairly technical, but it is covered in IRC Section 163(h)(3)(E) and in this article by Mr. Kitces, MSFS, MTAX, CFP, CLU, ChFC.*


Paying down a reverse and generating a deduction must pass scrutiny under the economic substance doctrine in order to be tax deductible.  Essentially, the borrower draws an equivalent amount from their IRA or 401(k), offsetting the taxable amount by the amount of the interest deduction.  Or, they use the deduction to offset an equivalent tax liability from a Roth conversion.*


Those are the key points to pass away, sell and move, or prepay.  The other strategic use of a reverse mortgage is to provide liquidity while married borrowers occupy to avoid having to sell and pay capital gains.  If the property is held in community property, in certain states the remaining spouse gets a step-up in basis and can then sell/downsize saving in some cases tens or hundreds of thousands of dollars. Check out this video based on a client conversation around this exact topic.


Next, we’ll summarize common issues for those in different income levels.



Considerations at Different Income Levels - IV


Low Taxable Income

When a borrower has modest taxable income in retirement, they are likely in that 45% group that can’t itemize deductions because the standard deduction is larger.  Those who do not itemize do not lose their mortgage interest deduction when they refinance a conventional mortgage into a reverse mortgage because they couldn’t use it in the first place.  However, albeit delayed, they may be able to write off reverse mortgage interest because it will build up to the point that it exceeds a standard decuction.


A low-income borrower may have qualified assets (IRA, 401k, etc.), so they may still be able to benefit by converting some of those assets to ‘create’ income and to take advantage of the large reverse mortgage interest deduction when the loan is paid off.


Since low-income borrowers are in a low tax bracket, the benefit of this strategy is admittedly less.  But if they can eliminate taxes on say a $50,000 conversion, and they have an effective tax rate of 12%, they’re saving nearly $6,000.  Waste not, want not.



Moderate Taxable Income

Those with moderate taxable income should consider the same strategies outlined above.  Their benefit of implementing the strategy may be greater because they are in a marginally higher tax bracket.



High Taxable Income

There are 15 million Baby Boomers who are considered mass affluent (net worth between $1.5million and $3 million).  Like all HECM borrowers, they usually have three objectives:

  1. Not outliving or running out of money
  2. Having a financial cushion for unexpected expenses
  3. Retaining choice and control to transfer wealth to others; a.k.a., a bequest motive


The main difference we see with the mass affluent is their use of a reverse mortgage as a wealth management tool.  Specifically, using of a reverse mortgage line of credit, in conjunction with a securities portfolio to stabilize and enhance retirement income.


Only the FHA-insured home equity conversion mortgage has a line of credit option.  Jumbo reverse mortgages tend to allow the homeowner to access more wealth when the home is worth more than $1 million and the youngest borrower is over 70, but they do not offer a line of credit.  The entire loan amount available has to be taken up front or the portion above 60% of the principal limit can be taken in equal monthly installments over the subsequent 12-60 months.


High-income reverse mortgage borrowers often do not need to ‘create income’ though the same strategies outlined above (qualified account distributions or conversions being offset with a large mortgage and MIP deduction) can be relevant.  We’ve devoted an entire section of our website to the mass affluent audience, including academic white papers and a Monte Carlo simulation calculator under the For Advisors/Resources section.




When it comes to reverse mortgages and taxes, reverse mortgage borrowers don’t lose their tax write-off, but how and when they can use it is different.  Reverse mortgages can be a powerful tool for retirement income planning, especially if potential tax deductions are mazimized. 


Home equity conversion mortgages don’t create wealth, but they do reposition it to better optimize a homeowner’s equity in support of their retirement income goals.  Being a good steward of wealth always includes legally minimizing taxes paid.


Hopefully this article has been an eye opener.  The most important takeaway is the importance and need to proactively engage tax and estate planning professionals to maximize the value of the reverse mortgage interest deduction and to address contingent liability around cancellation of debt income, in the event the loan balance exceeds the value of the house, and/or capital gains taxes.


For a complimentary consultation on your specific situation, click the Complimentary Consultation button below.  We work with many allied professionals – if you need a recommendation to a good one, let us know.


Complimentary Consultation




If you are a tax or estate planning professional, please review the sources cited below.  They better explain our modest attempt to summarize these topics for the average reader.  The authors and articles marked with an (*) asterisk are considered the gold standard on this topic - they are routinely mentioned in HECM industry literature.


If you would like to better understand your options, click the Reverse Mortgage Qualifier button below and we will generate a report from our reverse mortgage calculator based on your unique situation.


The Reverse Advisor Mortgage Qualifier



Resources Used or Referenced in Reverse Mortgages & Taxes


About the Author

Kent Kopen, Certified Reverse Mortgage ProfessionalKent Kopen earned his Reverse Mortgage Specialist credential in March 2007.  Last year Kent earned the CRMP (Certified Reverse Mortgage Professional) designation.  Note, there are less than 150 CRMP designees in the United States.  Mr. Kopen also provides education, tools, and strategies to professionals who offer financial and legal advice to others. "Our resources help financial advisors, CPAs, and estate planning attorneys help seniors optimize their home equity to provide greater security and peace of mind."