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Tax Deductions & Reverse Mortgages

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HECM Mortgage Interest Deductions Complexities

It’s a discussion you rarely overhear among reverse mortgage professionals, the tax deduction of interest charged in a home equity conversion mortgage. Perhaps it’s because such scenarios are not typical or it is the inherit complexities of tax law with a unique mortgage instrument.

tax-deduct-calcWell known industry pundit and financial professional Wade Pfau addressed the tax complexities of reverse mortgages in his March 10th column in Forbe’s Retirement. First proceeds from a reverse mortgage are typically not counted as taxable income. A notable advantage for those seeking other sources of cash flow without incurring the typical tax burdens associated with withdrawals from retirement savings and investment accounts such as 401(k)s, IRAs and event annuities. Higher net worth individuals may employ such a strategy to avoid slipping into a higher tax bracket.

While more affluent individuals may find advantages in this strategy lower income individuals…

Download a transcript of this episode here.

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8 Comments

  1. Regarding the “$100,000 cap” on mortgage non-acquisition/improvement interest deduction, I believe Pfau’s choice of words may be misleading. If I am not mistaken, the $100,000 cap is applied to the indebtedness, not the resulting interest; i.e., the deduction for non-acquisition/improvement is limited to the INTEREST paid on the first $100,000 of INDEBTENESS.

    • Mr. Warns,

      One has to very clear. There are three types of home mortgage indebtedness described in Internal Revenue Code 163(h)(3). First there is acquisition indebtedness which is fully deductible for regular income tax and alternative minimum tax purposes. Two homes can be considered for this purpose but one of them must be the principal residence. Only the interest on the first $1,000,000 of such debt is deductible for a tax year.

      The second type of home mortgage interest is interest related to home equity indebtedness where the debt is limited to $100,000 but it is only deductible for regular income tax purposes.

      The final category is personal interest which is not deductible at all.

      Based on the regulations, in order to determine the amount deductible, mortgagors must document the use of their proceeds so that interest can applied to its various categories. That will be explained in my response to Mr. Beach.

      Yet we all know a substantial percentage of reverse mortgage borrowers pay off existing mortgages at closing. That leads to the problem of trying to determine how the proceeds of the prior mortgages were used and how to apply principal payments against them. Refinanced mortgages allow mortgagors to keep in place the categories and related debt amounts that were associated with the existing mortgage immediately before refinancing. It is a carryover of income tax deduction attributes and is beyond the scope of this comment.

      It is helpful to read 2015 IRS Publication 936 in this regard.

  2. Years ago I helped a lawyer obtain a reverse mortgage. He felt the interest should be deductible every year, as opposed to waiting until the loan is repaid. His position was that interest was charged every month, taken from his side of the ledger to the investor’s side of the ledger. When that transfer takes place, he claimed it to be constructive receipt. Oddly enough, his accountant, from Deloitte and Touche, agreed. As far as I know, he has been deducting the amount of interest charged every year.

    • Mr. Beach,

      I have no idea what tax position you are espousing but it is clearly incorrect.

      Interest is only deductible when paid if the deduction must be taken on the cash method of accounting for income tax purposes. Based on use of proceeds and method of accounting for the cost of interest for such use, most reverse mortgage borrowers will only be able to deduct the interest as home equity indebtedness interest and acquisition indebtedness interest. Based solely on the use of the proceeds (or lack being able to document their use), many will have a great deal, if not all, of their interest nondeductible.

      As to investors who use some portion of their proceeds to acquire investments, that portion has its own rules. If investment interest expense is eligible for deduction under the accrual method of accounting, your former customer is correct as to the portion of the interest that can be deducted under the accrual method of accounting. It is rare that any individual is eligible for the accrual method of accounting for investment interest expense but it is possible but highly unlikely.

      If the proceeds are used in a pass through entity like a S Corporation, LLC, or partnership, the interest on the HECM may also be deductible on the accrual method depending if similar interest was deducted that in the past or if that is not the case, how interest is deducted by the pass through entity.

      So is there a chance your customer is right? Certainly but not due to some slight of hand bookkeeping explanation. Besides that before changes to Circular 230, the IRS guide governing the practice of income tax before the IRS by attorneys, CPAs, and EAs, one could do as instructed by the client as long as the client was made aware of the tax rules and decided the method he chose was correct. Once an incorrect accounting method is chosen it can only be changed by agreement with the IRS or IRS mandate.

      So please find out more from your former customer and let us know.

  3. Is there any information on how interest is deducted for tax purposes should a borrower have a reverse mortgage line of-credit and wish to make periodic repayments to the line? Seems like it would be an accounting challenge to calculate the portion of periodic repayments that apply to interest and what amount is applied to reductions in the principal balance. Thanks

    • Mr. Reisen,

      One must question if that is right course of action from an income tax planning point of view but putting that aside, there is a specific clause in the model HECM loan docs that requires a specific order to the application of prepayments to accrued MIP until that is paid off, next to accrued service fees, next to accrued interest, and finally principal.

      Under federal law if the interest or MIP paid during a calendar year exceeds $600, lenders receiving those payments are required to issue a Form 1098 to the payor no later than January 31 of the following year.

  4. Clarification: The interest deduction on acquisition indebtedness is based on $1,000,000 of debt. This will apply to use of HECM to buy, build or substantially improve a home, for example.

    The interest deduction on home equity indebtedness is based on $100,000 of debt, not $100,000 of interest. The interest could be larger than $100,000 over enough time. Home equity indebtedness would apply if the home were fully paid off, and then a HECM were obtained, as one example.

    First you must know the amount and type of debt, and then get the interest on that debt.


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