Reverse Mortgages and How They Can Help Your Tax Bill

Seniors who own their own home but are struggling with cash flow to make ends meet have a couple of options to help solve this challenge.  Many have been in their home for decades, and the home has appreciated in value considerably.  Sometimes, the sale of a home can produce the extra cash to help solve this problem.  But selling a home that has significantly appreciated may trigger an unwelcome tax bill from Uncle Sam.  Given how much homes have increased in value over the years, this tax bill could be in the hundreds of thousands of dollars!  Having a tax bill of that size may use up the additional cash gained by selling the house in the first place.

For those in this situation, a reverse mortgage could be a viable option to help solve both the cash flow while providing some tax benefits (e.g. avoiding that big tax bill upon the sale of your home).

If you’ve been reading my blog posts, you’ve learned some of the basics of a reverse mortgage.  Here’s a recap:

• A reverse mortgage uses equity in the house as collateral for the loan
• Borrowers must be 55 years of age to participate
• Borrowers must own the home outright or have paid off a good amount of current mortgage
• Home must be the permanent residence of the borrower
• The bank makes payments to the borrower

If you need some help with cash flow, a reverse mortgage could provide this.  Borrowers would be able to choose how they receive their cash whether it be a lump sum, fixed payments over time, a line of credit, or a mix of those options.  It really depends on your needs and preferences.

It’s important to remember that at the end of the day, a reverse mortgage is a loan.  And just like a traditional “forward” mortgage, there are fees associated with it.  You can expect an origination fee, servicing fees, insurance premiums (upfront and ongoing), and interest.  However, this doesn’t mean that you need to pay them out of pocket - these can all be rolled into the loan amount.  Borrowers also have a responsibility to stay up to date on homeowners insurance and property taxes as well as keeping the home in good shape.  

A reverse mortgage becomes due and payable under a couple of instances: when a borrowers dies or permanently moves.  A bank cannot go after heirs to pay the debt of a reverse mortgage, so if the borrowers pass away, the heirs can either decide to sell the house and use the money to satisfy the outstanding debt or do nothing and let the bank sell the house.  

So how does a reverse mortgage help the tax situation if the home has appreciated significantly over time?  There are a lot of details and fancy jargon about this tax basis step-up for appreciated capital gain assets in section 1014(a) of the IRS code that I’m not going to get into.  But I will explain it in real terms using some examples.

If you are married, and your spouse passes away, the basis of your spouse’s portion of the home (typically 50%) gets “stepped up” to fair market value (FMV).  When this happens, half of the appreciation is no longer in play for the IRS.  You would then own 100% of the house.  If you live there until your death, your 100% portion of the home gets “stepped up” to fair market value at the date of your death.  This would eliminate or significantly reduce the tax bill for your heirs if they decide to sell the house.  

It’s important to note that there are nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) where if you and your spouse own community property and one spouse dies, the entire 100% of the property is “stepped up” to fair market value.  This provides some added flexibility for the surviving spouse, as they would be able to sell the home and likely not face an enormous tax burden.  

In summary, a reverse mortgage could help by providing immediate cash and allowing seniors to avoid selling their house and triggering a potentially enormous tax bill.  However, it’s important to remember that a reverse mortgage is a loan, and does have pros and cons.