April 2017 update: Michael Kitces published “The Taxation of Reverse Mortgage Loan Proceeds and Interest Payments” on his Nerd’s Eye View blog on April 12, 2017. It has additional information on tax deductions. I recommend it to you.
August 2016 updates incorporated into this post: Additional identification of who can deduct reverse mortgage payments (homeowner, their estate, or their beneficiaries). Wording changes for simplicity.
If you have a FHA insured Home Equity Conversion Mortgage (HECM) you have the potential for valuable tax deductions.
- Interest is deductible when you pay it. You could pay it and deduct it on your annual tax return.
- Mortgage insurance premiums (MIP) are deductible when you pay it, if you use your loan to buy or substantially improve your home. If your HECM refinanced a loan that had been been used to buy or substantially improve your home that also counts.
- Real estate taxes you pay yourself have always been deductible. If your loan pays your real estate taxes, they may be deductible before you make payments on your loan.
- When you finally pay off a reverse mortgage there usually is a large interest deduction. Perhaps MIP and real estate tax deductions will also be available. These deductions could be quite large and are worth special planning.
It is useful to keep in mind that a HECM reverse mortgage is just a mortgage. The same tax principles apply to both reverse and traditional mortgages. Practical differences come because payments on a reverse mortgage often are not made until the end of the loan. Interest and other costs are added to the loan balance instead of being paid monthly. Deferred payments create the question of when these costs can be deducted. These notes are an introduction to the tax opportunities and obligations that go with annual tax reporting while you have a reverse mortgage. See your professional tax preparer for authoritative advice and proper application in your situation.
Loan Proceeds are Not Taxable Income
Money you get from your reverse mortgage is not taxable income so it isn’t reported on your tax return. IRS Publication 936 “Home Mortgage Interest Deduction,” says “Because reverse mortgages are considered loan advances and not income, the amount you receive is not taxable.” This just like a traditional mortgage where you aren’t taxed when you receive funds to buy a house or take money out of a home equity line of credit. As your reverse mortgage is not taxable income it does not affect government benefits such as Social Security.
Interest is the largest potential deduction. The IRS says “Any interest … accrued on a reverse mortgage is not deductible until you actually pay it, which is usually when you pay off the loan in full.” (Publication 936 “Home Mortgage Interest Deduction”). This is an old rule that the IRS established in 1980. This creates valuable tax planning opportunities as homeowners with reverse mortgages control when mortgage payments are made, and thus when tax deductions are created.
If no payment is made in a month, that month’s interest is added to the loan balance. The following month interest is charged on the entire balance, including the prior month’s interest. This results in “interest on interest”. Deduction of the “interest on interest” is not explicitly addressed in tax rules but will follow the standard rules. Interest on interest is analyzed in “Recovering a Lost Deduction” by Barry Sacks and co-authors in the April 2016 Journal of Taxation and is available at “Recovering a Lost (Large!) Income Tax Deduction”.
Who Can Deduct Mortgage Interest on a Reverse Mortgage
The person who pays mortgage interest when they own the house can deduct the interest.
- Homeowner/Borrower: If the borrower pays off the loan while they are alive, they can deduct the interest payment.
- Homeowner’s estate: If the estate pays off the loan, the interest is deductible on the estate’s income tax return.
- Beneficiary: If beneficiary(ies) who have inherited the house pay off the loan, they can deduct the interest on their personal tax return(s).
If, instead of paying off the loan, the home is turned back to the lender by a deed in lieu of foreclosure the mortgage interest appears to not be deductible.
Acquisition versus Home Equity Debt
Interest deductions are different for acquisition versus home equity debt.
Home equity debt: If you have a home with no mortgage, you have full equity in it. If you then take out a loan on your house it would be home equity debt. The traditional “Home Equity Line of Credit” has that name as it is taken out on the equity in your home.
Acquisition debt is debt used to buy, build, or substantially improve your house. Refinanced acquisition debt is still acquisition debt. If you refinance acquisition debt and also take more money out the new mortgage is part acquisition and part home equity debt. The extra money you took out is a loan against the equity in the house.
Interest on up to $1,000,000 of acquisition debt is deductible ($500,000 for a married person filing separately).
Interest on up to $100,000 of home equity debt is deductible ($50,000 for married filing separately). This does NOT say “up to $100,000 of interest on home equity debt is deductible”. The limit is on the amount of debt, not the amount of interest on that debt. If you have home equity debt of $100,000, over enough years the interest could grow to well over $100,000. It would all be deductible! A special caveat is home equity debt is not deductible in computing Alternative Minimum Tax (AMT).
Real Estate Tax Deduction
Most reverse mortgage holders pay their real estate tax themselves. In a few loans the reverse mortgage servicer directly pays the real estate tax. Loans originated since April 27, 2015 could have a new feature known as a Life Expectancy Set Aside (LESA). A LESA sets aside, or reserves, a part of the loan capacity amount which the lender draws on to make payments of property taxes, homeowner’s insurance and flood insurance premiums on the homeowner’s behalf.
As the LESA arrangements for real estate tax are new, your lender may or may not report these payments to you on IRS Form 1098. If your lender reports these payments on your Form 1098 they were also reported to the IRS, and if you deduct them the IRS will have matching information. A practical approach might be to deduct the payments if on the 1098 and not deduct them if they are not there. It appears that these real estate tax payments are deductible by the homeowner in the year they are made.
I am not aware of any IRS position on the deductibility of real estate tax paid by a lender from a LESA or when the lender pays real estate tax when the homeowner is delinquent. When the IRS is silent, you must rely on standard tax logic as the IRS can’t address every imaginable situation. In this case, as a non-expert, it seems to me a reasonable case is that the loan servicer is acting on your behalf as your agent. This is similar to traditional mortgages where you are making payments and the loan servicer pays real estate tax and mortgage insurance for you.
Barry Sacks offers an analogy to a common practice of using a credit card to make tax-deductible payments. The credit card company is acting as your agent. Barry says: “If one makes a payment for something deductible (e.g., property tax) in December of Year 1, using a credit card, and then pays off the credit card debt in January of Year 2, the deduction is taken in Year 1. The proper characterization of the transaction is that the credit card company has loaned you money in December (which is not a taxable event), the money was used in December to make the payment (which is a deduction event), and then in January the loan was repaid (which is not a deduction event). In the case of the real estate payment, the loan servicer is in the role of the credit card company, and the fact that the loan was repaid much later is not relevant for tax purposes.”
A Layer Cake: What Part of A Loan is a Payment Applied To?
If you choose to make a loan payment what part of the loan balance is it applied to? For tax planning you need to know. The loan balance is like a layer cake: the bottom layer is loan principal, interest is next, then servicing fees, and the top layer is mortgage insurance.
When you make a payment you eat through the cake from the top down. You have to finish a layer before you get to the one below. If you have never made payments the top layer of mortgage insurance will have built up. It may take a lot of dollars to pay down mortgage insurance and then servicing fees before you get to paying interest. A withdrawal from the loan adds to the loan’s principal, at the bottom layer.This is the common order of layers. To make sure it matches your loan you could check your loan agreement or call your loan servicer.
Regardless of the details of your payment’s tax treatment all of it pays down the loan balance. And if you have a line of credit it becomes available to borrow again in the future (plus any future growth).
Bunching Interest Payments
Common tax deductions are state and local income tax, charitable gifts, and medical expenses. The three housing related deductions are real estate tax, home mortgage interest, and mortgage insurance premiums. You report itemized deductions on Schedule A of your tax return.You might pull out your tax return for last year to see what was there, and if you got a benefit from the itemized deductions. Look at line 40 on your 1040 and at Schedule A.
Bunching is the strategy of collecting deductions on that might be spread over several years onto one year’s tax return. The goal of bunching is to get a bigger tax benefit by either exceeding the standard deduction and/or taking advantage of an unusually high marginal tax rate.
Deductions only provide a benefit if your itemized deductions added together are more than your standard deduction. In 2016 the standard deduction is $15,100 for a married couple both ages 65 or older. If their deductions total $15,100 or less, there is no added value from itemizing deductions. If their deductions add up to $16,100 that’s an extra $1,000. If their marginal tax rate is 25% the extra $1,000 deduction saves $250: 25% of the $1,000 amount over the standard deduction. $250 is the tax savings of itemizing. The tax savings are larger the further you are over the standard deduction and the higher your tax bracket.
Reverse mortgages provide an interesting opportunity as you may, but don’t have to, make payments until the end of the loan. For example interest is deductible only in a year when it is paid. You may choose to not make interest payments for years, and then make a large payment. Then you could have a large interest deduction and easily exceed your standard deduction. It would be even more beneficial if you were in an unusually high tax bracket. An example is someone in their late 60’s who may be bumped up a tax bracket when their required minimum distributions start at age 70.5. That could be a good year to make a reverse mortgage payment. For expanded discussion about bunching strategies see Income Tax Planning with a Reverse Mortgage on this blog.
An extreme bunching example is when you would like a very large deduction some year due to unusual circumstances. Then you could refinance your reverse mortgage with a new reverse mortgage, paying off all the deductible items at once. You could even offset the taxes for a conversion of a regular IRA to a Roth IRA! Refinancing could be particularly useful if your house value appreciated nicely so it was well above the size of your loan balance.
Cash Flow for Bunching Deductions
Where do you get the cash to make a loan payment and get a tax deduction? If you have a variable rate reverse mortgage loan it has a line of credit. The line of credit is designed to help you with cash flow, and you could draw on it in your bunching strategy.
Perhaps you took cash from another source like a savings account and made a reverse mortgage payment. The payment increases the amount of cash available in the line of credit and counts against the layer cake of charges described below. You can later draw cash out of the reverse mortgage and put it back in your savings account if you wanted to. Or flip the order: first take money out of the reverse mortgage and then put it back in as a payment. Note that takes it out of principal and puts it back in replacing MIP – see the layer cake analogy.
If there were a very short time interval, like a day or a week, between the payment into and withdrawal from the reverse mortgage the IRS would disallow the deduction. If there is a long enough time and there’s reasonable risk of whether the money will be available later, this method may be acceptable to the IRS. This follows what’s called the Old and Cold Doctrine: “This unstated rule is generally known to tax practitioners. At some points, events are so old and cold that they acquire reality by themselves and cease to be part of an overall plan or transaction; hence, the Substance Over Form Doctrine would not apply. How long this takes is unclear.” Quoted from Top 40 Tax Doctrines.
When the payment and withdrawal transactions are close together in time the IRS may see them as effectively cancelling each other out. They see no material change in your overall financial situation even though there was money moving around. In the example the line of credit is stable and the savings account is stable, and the total dollar amount you had in the two stable accounts didn’t change. Therefore your risk didn’t change. (That’s called a step transaction in the tax world: you took two steps, but there is no material overall change to your financial situation other than possibly a tax change; therefore there should not be a tax change). However, if you were exposed to risk in the time the money went in and out of the reverse mortgage then it may not be a step transaction and a deduction is allowable. For example, if you took money out of the stock market to pay the loan down and later put it back into the stock market that may satisfy the IRS: you had the risk of losing money while you were out of the stock market. Without anything as dramatic as exposure to the stock market a gap in time may count. Depending on your situation several months (four??) could be sufficiently long as something reasonably could have changed in your situation during that time if the funds were commingled with funds for other purposes.
Reports on Your Loan: Monthly Statements and IRS form 1098
Each month you will receive a current month statement showing what charges are made to the loan, including for interest and mortgage insurance. Early the following year you will get a year-end summary and an IRS Form 1098 Mortgage Interest Statement. The 1098 has boxes for Mortgage Interest Received, Outstanding Mortgage Principal, Mortgage Origination Date, Mortgage Insurance Premiums and real estate taxes. The 1098 may not report all the values, depending on your situation. It may not be issued if the interest is less than $600. If a number shows up on the 1098 it is reported to the IRS (Box 10 “Other” is an exception, showing information to be reported to the payer, but does not need to be reported to the IRS.) Simply the existence of “reportable” information on the 1098 does not mean it is always deductible. Most notably, the interest amount may include interest on acquisition debt, home equity debt, and interest on interest of both types.
Can “Interest on Interest” be acquisition indebtedness? The authors of the Sacks et. al. paper mentioned above take an intentionally conservative definition of acquisition indebtedness, classifying interest on acquisition indebtedness as home equity debt. Classifying it as acquisition indebtedness would be more generous to the taxpayer as there is a much higher limit on amounts that can be deducted. Allowable classifications is another apparently unknown area of the tax rules.
How broad is the category of deductible interest? In two interesting situations with traditional mortgages other charges can be treated as home mortgage interest. (1) When people fall behind on their payments or stop making them altogether a late payment charge can be assessed in addition to the interest that accrues. (2) If you pay off a traditional mortgage early, you may have a prepayment penalty. Neither the late payment charge nor prepayment charge is interest, but the IRS says they are deductible as interest as long as they weren’t for a specific service or cost performed in connection with the loan. And presumably they could be treated as acquisition interest.
This observation does not clarify if “interest on interest” can be considered acquisition debt. But perhaps it shows the IRS has a practical rather than purist approach.
Mortgage Insurance Premium (MIP) Deduction
Mortgage Insurance Premium (MIP) is deductible in the year you pay it.
For MIP payments to be deductible:
- The loan must be for acquisition debt. Mortgage insurance on home equity debt is not deductible (see description below). A loan may be part home acquisition and part home equity debt. Only MIP on the acquisition debt portion is deductible. Many HECMs are only home equity debt. An example of home equity debt would be if you had no mortgage at all, and then got the HECM. In that case you were borrowing against the equity in your home.
- You must have paid the MIP to the lender during the tax year, by either paying closing costs out of pocket or making loan payments.
- MIP payments are fully deductible if your Adjusted Gross Income (AGI) is $100,000 or less ($50,000 if married filing separately). If your AGI is more than $109,000 ($54,500 if married filing separately) you can’t deduct mortgage insurance. In between those limits your deduction is reduced.
- Your loan (the mortgage insurance contract) must be issued after 2006.
- The mortgage insurance may be referred to as Private Mortgage Insurance (PMI) or Mortgage Insurance Premium (MIP).
A MIP deduction will be particularly useful when you buy a house and use a reverse mortgage to pay for it. The reverse mortgage business often calls this “HECM for Purchase” (or H4P for short). All HECM reverse mortgages have FHA mortgage insurance. When the loan is first set up there is a one-time mortgage insurance premium. Then there is a monthly charge based on the current loan balance. Your loan servicer pays premiums to HUD and adds them to the loan balance.
MIP on acquisition debt was made deductible in the Tax Relief and Health Care Act of 2006. The deduction came with an end date and has been extended several times. December 2015 brought another “tax extender” law allowing MIP deductions in 2015 and 2016. MIP will not be deductible after 2016 unless it is extended again. If you can deduct MIP and would like to make payments to keep your loan balance down, you may want to pay MIP in 2016 as it may not be deductible in the future. And any payment made on the loan is first allocated to MIP – see the “Layer Cake” discussion.
Unless you pay MIP, the vast majority of lenders do not report accrued MIP to you on your 1098 and to the IRS. If it is on your 1098 your lender reported it to the IRS.
MIP is described in IRS Publication 936 and the 1040 Schedule A instructions. For more on MIP deductions see MIP discussion in 2009. The underlying tax logic suggesting that MIP is not deductible if you don’t pay it is there is no principal agent responsibility given by the homeowner to the servicer to pay MIP. FHA looks to HECM lenders for the payment. Lenders, in turn, look to secondary market investors for reimbursement of those payments.
For Further Information
This discussion assumes the homeowner is a cash basis taxpayer who uses loan proceeds for personal, not business, purposes.
IRS Publication 926 (“Home Mortgage Interest Deduction”), and the Instructions for 1040 Schedule A have helpful information on deducting mortgage interest and mortgage insurance premiums. IRS Publication 530 (“Tax Information for Homeowners”) discusses real estate tax payments in addition to interest and mortgage insurance. Vorris Blankenship covers much of this material and provides Internal Revenue Code citations.
IRS Revenue Ruling 80-248 clarifies when you can deduct interest on a reverse mortgage. IRS Publications 554 and 936 both state the rule correctly: “Any interest (including original interest discount) accrued on a reverse mortgage isn’t deductible until you actually pay it, which is usually when you pay off the loan in full.” Unfortunately IRS Publication 17 (“Your Federal Income Tax”) has it wrong, saying “interest …isn’t deductible until the loan is paid in full”. Additional background is provided at Inconsistent IRS documents.
Naturally you can Google “reverse mortgage” with words like interest and deduction to find help. Always be wary of comments by individuals on taxes, but be especially wary of taxes related to reverse mortgages. And Publication 17 being wrong doesn’t help!
Acknowledgments and Disclaimer: Jim Veale has provided invaluable background and support in getting this paper started. Tom Dickson from Financial Experts Network provided access to tax and legal resources. Joe DeMarkey of Reverse Mortgage Funding provided key information on HECM processes, evolution and current practices across the lending industry. Barry Sacks and other reviewers provided valuable comments.
The big disclaimer: None of these individuals have responsibility for the final document. I am not a tax professional, and the document is based on my synthesis of available information. I’ve tried to indicate what is “IRS blessed” and what is not. The document is intended to be an introduction to these topics and provide a general awareness of possibilities. It intentionally does not cover all nuances that may affect an individual’s situation. The bottom line: Use at your own risk! Please refer to your own tax professional and estate planner for advice, especially as it applies to your situation.