By: Martin M. Shenkman, CPA, MBA, JD
How can an elderly client stay in their home and avoid entering a nursing home? While perhaps most elderly clients prefer this option, financially it is often not viable. However, a reverse mortgage might unlock the resources to pay for in home care, enabling you to guide a client to achieving important late in life lifestyle objectives. More than half of the elderly own their own houses free and clear of any mortgages. However, many are living on fixed incomes, consisting of Social Security, pensions, dividends, and interest. Thus, there can be tremendous equity in a senior’s house while the senior homeowner struggles with cash flow problems. This dilemma has been exacerbated by the current low interest rates, which have reduced the income, which many seniors view as available. The pressure of this loss of cash flow will encourage more seniors to enter reverse mortgages and other arrangements. With a reverse mortgage, a lender/investor pays the homeowner a check each month, and at the end of the mortgage term, the lender will own an equity interest in the house. Many reverse mortgages are often called “Home Equity Conversion Mortgages” (“HECM”) and may insured by the federal government. These are typically non-recourse mortgages that provide periodic cash advances based on the equity value of the house. Generally, no principal or interest payments are required until the reverse mortgage becomes due and payable. This occurs when the home is sold or transferred, the borrower ceases to occupy the residence or other specified circumstances.
Reverse mortgages can also help senior clients access the equity in their houses to supplement their retirement income without taking out a home equity loan. When the client obtains a mortgage from a bank, he or she will have to make monthly payments for a period of time until he or she repays the mortgage. After the client has paid off the mortgage, he or she will own the house outright. A reverse mortgage is similar, but in a sense, the opposite. Under this scenario a lender (or an investor) agrees to make monthly payments to the senior (or perhaps a large payment at inception). At the end of the payment term (which could be a certain number of years or until death), the lender/investor will own a portion or the senior’s entire house. The senior’s house may then be sold, and the lender/investor repaid the funds loaned with interest, and possibly with some of the appreciation in the senior’s house as well, depending on how the transaction was structured. Meanwhile, the senior has had the opportunity to continue living in his or her house as desired, and has presumably been able to supplement his or her retirement income. Reverse mortgages are typically limited to a percentage of the fair market value of the client’s home. The recent drops in housing values, some precipitously, may make this technique less beneficial than might have been anticipated when the client, and his or her family, first began evaluating this option. Also, the analysis of this technique is not simple. A determination of the actual costs on a particular reverse mortgage, including interest and closing costs, loss of flexibility, availability of other options, etc. all need to be considered.
The tax consequences of a reverse mortgage will depend on the exact legal nature of the transaction. The transaction could be structured as a loan, so that there would be no tax consequences to your client on the receipt of monthly or other payments. Alternatively, the transaction could appear to be an installment sale. If this were the case, a portion of each payment received by your client would be taxable as capital gains on the sale of the house. Interest expense is deductible by the borrower when it is actually paid by the borrower. Actual or constructive payment does not occur when the interest is added to your client’s outstanding loan balance. See Rev. Rul. 80-248, 1980-2 CB 164.
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