by Vorris J. Blankenship, J.D., CPA
Vorris J. Blankenship is a retired attorney and CPA. He is the author of "Tax Planning for Retirees," a treatise published by LexisNexis.
A reverse mortgage allows a taxpayer to draw down home equity tax-free. The taxpayer can generally choose to withdraw the equity as monthly payments, as a lump sum, as a flexible line of credit, or as a combination of those types of payments. Furthermore, the taxpayer need not make mortgage payments so long as the taxpayer (or taxpayer or spouse) continues to live in the home. Interest on the aggregate drawdown generally accrues unpaid until the taxpayer (or taxpayer or spouse) no longer occupies the residence.
Thus, when the taxpayer (or taxpayer and spouse) ceases to occupy the residence, the taxpayer, spouse, or his or her estate or heirs will normally sell the residence and pay the balance of the mortgage and accumulated interest. However, the total repayment is limited to the amount of the proceeds of sale. On the other hand, if there is any remaining equity in the residence, the taxpayer or spouse, or his or her heirs, are entitled to it.
Deductibility of Interest
Some or all of the interest accrued on a reverse mortgage may be deductible, but only when the interest is actually paid.1 Although the taxpayer could choose to pay some or all of the interest during the term of the mortgage, the taxpayer would normally wait until the mortgage terminates. No interest is deductible unless the reverse mortgage is secured by the taxpayer's principal residence or a second residence designated by the taxpayer.2
Acquisition Indebtedness. As with other types of mortgages, a taxpayer (or his or her estate or heirs) may deduct interest paid on only certain portions of loan proceeds.3 One such portion is the amount of the proceeds representing acquisition indebtedness.4 That is, interest accrued and paid on the portion of reverse mortgage proceeds used to acquire, construct, or substantially improve the mortgaged residence is generally deductible as acquisition indebtedness. Similarly, the taxpayer (or his or her estate or heirs) may generally deduct interest accrued and paid on the portion of the proceeds used to refinance previously existing acquisition indebtedness.5 However, no more than $1,000,000 of the reverse mortgage proceeds will qualify as acquisition indebtedness ($500,000 for a married individual filing separately).6
Home Equity Indebtedness. The taxpayer (or his or her estate or heirs) may also deduct interest on an additional $100,000 of the loan proceeds if it qualifies as home equity indebtedness ($50,000 for a married individual filing separately). To qualify, the amount of the home equity indebtedness can be no greater than the excess of the fair market value of the residence over the amount of acquisition indebtedness discussed in the preceding paragraph.7 For this purpose, the IRS has held that acquisition indebtedness does not include the portion of indebtedness incurred to acquire or improve a residence that exceeds $1,000,000. Thus, up to $100,000 of that excess may instead qualify as home equity indebtedness.8
Unfortunately, interest on home equity indebtedness is not deductible for alternative minimum tax (AMT) purposes (though the AMT deduction is available for acquisition indebtedness).9
Indebtedness Incurred to Earn Tax-Exempt Income. The tax law disallows deductions for (1) interest expense allocable to tax-exempt income or (2) interest expense paid on funds used to purchase or carry tax-exempt obligations, or life insurance or annuity contracts.10 However, this provision will not ordinarily disallow mortgage interest expense "since a personal purpose unrelated to the obligations, insurance or annuity ordinarily dominates the transaction," e.g., the personal purchase or improvement of a residence, retirement planning, estate planning, etc.11
The IRS has specifically ruled that it will not disallow interest paid on borrowings (1) used to make IRA contributions or (2) used in lieu of IRA distributions. The IRS reasoned that IRA income is merely tax-deferred, not tax-exempt.12 The same should be true of most income earned by retirement plans. In contrast, income earned by Roth IRAs or designated Roth accounts may be truly tax-exempt since the income is not taxable when earned and any eventual "qualified" distribution of that income is also nontaxable.
Nevertheless, before a Roth distribution qualifies as nontaxable (e.g., during the usual five-year waiting period), the mere deferral rationale of the IRS could conceivably apply to a Roth IRA or a designated Roth account. Even after distributions qualify as nontaxable, a taxpayer might argue that personal reasons for a reverse mortgage override any inference that the taxpayer used the borrowing to maintain a Roth IRA or designated Roth account.13
Note that a special grandfather provision applies to interest paid on reverse mortgages entered into on or before October 13, 1987.14
Deductibility of Points
A mortgagee generally charges points as an offset for a lower interest rate, and usually computes the points as a percentage of the amount borrowed. Points that satisfy certain statutory or IRS criteria may qualify for deduction in whole or in part.15
The portion of such points allocable to acquisition indebtedness, other than the refinancing of such indebtedness, is generally deductible in full when paid.16 However, the points are not necessarily immediately deductible if the mortgagee offsets them against the loan proceeds. Instead, the taxpayer must either pay the points in cash from separate funds17 or pay a cash amount of closing costs that is at least equal to the amount of the points (whether or not the mortgagee explicitly applies the cash to the points).18
The portion of points allocable to home equity indebtedness and the refinancing of acquisition indebtedness is generally not deductible at closing whether or not then paid in cash. Rather, the taxpayer may amortize and deduct the points ratably over the term of the mortgage. Finally, a taxpayer may not amortize or deduct any portion of the points allocable to any remaining categories of mortgage indebtedness.19
Deductibility of Mortgage Insurance Premiums
For reverse mortgages entered into after 2006, the portion of mortgage insurance premiums that relate to acquisition indebtedness is generally deductible as interest. However, the deduction is not available for the portion relating to other types of indebtedness, such as home equity indebtedness. In addition, the tax law phases out the deduction rather abruptly for taxpayers with adjusted gross income exceeding $100,000 ($50,000 for a married individual filing separately). Furthermore, the deduction is not available at all for premiums paid or accrued after 2010.20
Prepaid premiums treated as interest are not immediately deductible if paid for private mortgage insurance or mortgage insurance provided by the Federal Housing Administration. Instead, a taxpayer may amortize and deduct the prepaid premiums ratably over the shorter of (1) a period of 84 months or (2) the stated term of the mortgage. However, unamortized premiums are not deductible if the mortgage is satisfied before its stated term.21
Gain or Loss on Termination of a Reverse Mortgage
Upon termination of a reverse mortgage, a taxpayer will generally realize gain or loss on the sale or disposition of the secured residence. The gain or loss is generally treated the same as gain or loss on the sale or disposition of any other residence. That is, a loss is not deductible.22 A gain is taxable as a capital gain, but only to the extent it does not qualify for the exclusion from gross income available for the sale or disposition of a principal residence.23
Requirements for the Exclusion. The exclusion is generally available if the following conditions are satisfied. The taxpayer generally must not have sold any other residence to which the exclusion applied during the two years immediately preceding the sale.24 The taxpayer generally must have owned the residence, and used it as his or her principal residence, for periods aggregating at least two years during the five-year period preceding the sale.25 The periods of ownership and use need not be concurrent.26 In addition, an unmarried surviving spouse may include periods of qualifying ownership and use by his or her deceased spouse.27
Note that the period of use as a principal residence generally includes the time a taxpayer spends in an assisted living or skilled nursing facility due to the taxpayer's mental or physical condition. However, to qualify, the taxpayer must have actually owned and resided in the principal residence for periods aggregating at least one year during the five-year period preceding the sale.28
Limitations on the Exclusion. The exclusion cannot exceed $250,000, or $500,000 on a joint return. To qualify for the $500,000 exclusion, both spouses must satisfy the requirements for the exclusion, except that only one spouse need satisfy the two-year ownership requirement.29 An unmarried surviving spouse may also claim the $500,000 exclusion if (1) the requirements for the exclusion were satisfied immediately before the death of his or her spouse and (2) the residence is sold within two years of the spouse's death.30
Nonqualified use of the residence after 2008 generally reduces proportionately the amount of gain qualifying for the exclusion. For this purpose, nonqualified use generally means all uses other than as a principle residence of the taxpayer or his or her spouse or former spouse. However, nonqualified use does not include any use during the portion of the five-year period falling after the last day of use as a principle residence. The taxpayer computes the reduction in the amount of gain qualifying for the exclusion by multiplying the gain by a fraction. The fraction is the sum of the aggregate periods of nonqualified use divided by the taxpayer's period of ownership.31
Partial Exclusion for Early Sale Due to Changed Circumstances. A taxpayer who sells his or her residence because of changed circumstance may be entitled to a scaled-down exclusion even though the taxpayer has not satisfied the two-year or five-year requirements.32 The scaled-down exclusion is generally available for a sale that is primarily due to one of the following changed circumstances:
- A change in place of employment of the taxpayer, the taxpayer's spouse, or another individual living with the taxpayer.33
- A change in health of the taxpayer, the taxpayer's spouse, another individual living with the taxpayer, or certain other related individuals - if the change requires certain medical or personal care.34
- Unforeseen circumstances of a generally detrimental nature.35
The taxpayer computes the available scaled-down exclusion by multiplying the full exclusion by a fraction. The numerator of the fraction is the shortest of (1) the aggregate periods of ownership during the five-year period, (2) the aggregate periods of use as a principle residence during the five-year period, or (3) the period between the date of the most recent prior sale qualifying for the exclusion and the date of the current sale. The denominator is two years.36
1 Rev. Rul. 80-248, 1980.2 C.B. 164.
2 I.R.C. § 163(h)(3)(B)((i), (C)(i).
3 I.R.C. §§ 163(h)(1), 163(h)(2)(D), 691(b)(1); Treas. Reg. § 1.691(b)-1(a).
4 I.R.C. § 163(h)(3)(A)(i).
5 I.R.C. § 163(h)(3)(B)((i).
6 I.R.C. § 163(h)(3)(B)((ii).
7 I.R.C. § 163(h)(3)(A)((ii), (3)(C).
8 Priv. Ltr. Rul. 200940030. To the contrary, see Pau v. Commissioner, T.C. Memo. 1997-43; Catalano v. Commissioner, T.C. Memo. 2000-82.
9 I.R.C. § 56(e), (b)(1)(C)((i).
10 I.R.C. § 164(a)(2), (4); I.R.C. § 165(a)(1), (2), (4).
11 Rev. Proc. 72-18, 1972-1 C.B. 740, clarified by Rev. Proc. 74-8, 1974-1 C.B. 419, modified by Rev. Proc. 87-53, 1987-2 C.B. 669. See also Wisconsin Cheeseman, Inc. v. United States, 388 F.2d 420 (7th Cir. 1968). But see Treas. Reg. § 1.163-10T(b).
12 Priv. Ltr. Rul. 8527082; Priv. Ltr. Rul. 8617044.
13 See supra note 10.
14 I.R.C. § 163(h)(3)(D).
15 I.R.C. § 461(g); Rev. Proc. 94-27, 1994-1 C.B. 613 (safe harbor not necessarily applicable to home improvement or refinancing mortgages or to mortgages on second homes).
16 I.R.C. § 461(g)(2); Rev. Rul. 87-22, 1987.1 C.B. 146.
17 Schubel v. Commissioner, 77 T.C. 701 (1981).
18 Treas. Reg. § 1.6050H-1(f)(3)(ii), Example 1; Rev. Proc. 94-27, 1994-1 C.B. 613.
19 Rev. Proc. 87-15, 1987-1 C.B. 624. But see Huntsman v. Commissioner, 905 F.2d 1182 (8th Cir. 1990) (points paid on the refinancing of a short-term purchase loan were immediately deductible since the refinancing was treated as a mere a continuation of the original purchase loan).
20 I.R.C. § 163(h)(3)(E).
21 I.R.C. § 163(h)(4)(E), (F); Treas. Reg. § 1.163-11T; 2008-4 I.R.B. 313, Notice 2008-15.
22 I.R.C. § 165(c); Treas. Reg. § 1.165-9(a).
23 I.R.C. § 121.
24 I.R.C. § 121(b)(3)(A).
25 I.R.C. § 121(a).
26 Treas. Reg. § 1.121-1(c)(1), (c)(4) (Example 3).
27 I.R.C. § 121(d)(2); Treas. Reg. § 1.121-4(a).
28 I.R.C. § 121(d)(7).
29 I.R.C. § 121(b)(1), (2); Treas. Reg. § 1.121-2(a)(3).
30 I.R.C. § 121(b)(4).
31 I.R.C. § 121(b)(5).
32 I.R.C. § 121(c).
33 Treas. Reg. § 1.121-3(c), (f).
34 Treas. Reg. § 1.121-3(d), (f).
35 Treas. Reg. § 1.121-3(e).
36 I.R.C. § 121(c)(1); Treas. Reg. § 1.121-3(g).