Recovering a Lost Tax Deduction: April 2016 Update

Reverse mortgages provide access to cash and may provide large tax deductions. Reverse mortgages are unique as borrowed funds don’t have to be paid back until the homeowner permanently leaves the house. Payback may be many years after the loan was set up. Interest can accumulate inside the loan resulting in a large loan balance, including a large amount of interest. Payment is usually made when the home is sold, often after the borrower’s death. When the interest is paid it is potentially deductible, but the tax deduction is often lost.

Sacks et al – Recovering a Lost Deduction, a study by Dr. Barry Sacks and his co-authors, lays out this potential deduction and how to capture it. The key is matching income and the interest payment on one year’s tax return. Planning ahead of time is needed to take maximum advantage of the potential deduction.

The paper was published in the April 2016 issue of the Journal of Taxation, pages 157 – 169.  Click here for a summary: Recovering a Lost Deduction – Summary. For a presentation based on an earlier version see: Recovering a Lost Deduction Presentation.

In some cases the homeowner(s) will sell the home, perhaps when they move to a care facility. In settling up the loan they pay the interest. They may want to generate more taxable income to take advantage of the interest deduction. If they have an IRA/401k, this could be an optimal year for a Roth IRA conversion or simply to distribute funds from the IRA. Likewise, a deathbed Roth conversion may be useful. (Alternatively, if the heirs take the deduction, they could do a Roth conversion of their own IRA, or use the deduction to offset other taxable income).

Many times the home is sold after the homeowner’s death. Especially in these cases pre-planning is needed, including how the home is titled (e.g., Transfer on Death) and IRA/401k beneficiary designations. A goal may be for the heirs to inherit the house, sell it and pay off the reverse mortgage, AND inherit the IRA. They could convert to a Roth or liquidate, matching the taxable income with the mortgage interest deduction.

Dr. Sacks and his co-authors lay out the details of interest buildup inside the reverse mortgage, and explore the potential for a homeowner’s IRA to grow, especially when cashflow to meet the homeowner’s living expenses is augmented by reverse mortgage proceeds. They offer examples of homeowners using reverse mortgages along with IRAs to improve retirement income, while at the same time creating a financial cushion during their lives and leaving a large estate.

They analyze two scenarios. The first has a homeowner downsizing, buying a home:

“A 67-year-old retiree has a rollover IRA worth $1 million, invested in a typical securities portfolio. He also has a home, with a value of $1.13 million, with an ordinary mortgage secured by the home, with a $500,000 outstanding balance (thus, with equity of $630,000). The retiree wants to sell the current home and downsize to a new home that will cost $850,000, but he will have only $600,000 from the sale of his current home, after commission and closing costs. He will need about $40,000 per year (inflation adjusted) plus Social Security, for living expenses (including income taxes) without needing any amount to service a mortgage.”

“The retiree described in the opening scenario can proceed in either of two ways to obtain the additional $250,000 needed to purchase the new home:

  1. Withdraw from the IRA (reducing it from $1,000,000 to $640,000, i.e., $360,000 is withdrawn, of which $110,000 is used to pay the income tax on the $360,000, leaving $250,000 for the home purchase).
  2. Obtain a reverse mortgage loan for $250,000.”

Their homeowner has three major financial objectives: “cash flow survival, cushion for emergency, and making a bequest.”  Their analysis shows using the reverse mortgage “yields better results for all three of the retiree’s financial objectives than the IRA transaction.”

They then analyze the amount of interest that may build up on the loan in various conditions. For example, they find that at a 6% interest rate, the homeowner will have $300,000 of interest after 20 years, and $450,000 of interest after 30 years.  When the home is sold and the loan settled, this amount of interest is paid off and available as a large income tax deduction. The authors highlight one way to use the deduction is in concert with a 401(k) or IRA account which could either be withdrawn or converted to a Roth, with the deduction paying the tax cost.

For annual tax planning when homeowners make payments on their reverse mortgage see Tax Deductions and Reverse Mortgages and Income Tax Planning with a Reverse Mortgage.

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