The countdown to Tax Day, April 15, has begun! From gathering receipts and documents to navigating complicated tax codes, it’s natural for this time to feel overwhelming. Taking your time and creating an organizational system to use throughout the year can help reduce stress and streamline your tax process come the deadline. For questions about specific finances, we recommend consulting your CPA or trusted tax professional. However, to help you navigate tax season, we’ve gathered some relevant tax-related information specific to reverse mortgages – also known as Home Equity Conversion Mortgages (HECMs).
So, let’s address the central question: are reverse mortgage funds considered income? Simply put, no! The proceeds you receive from reverse mortgages are income tax-free.1 But before we dive into other tax implications from a reverse mortgage, it’s important to establish the fundamentals about this type of loan.
Reverse Mortgage Basics
How does it work?
A HECM reverse mortgage is a home equity solution specially designed to help homeowners 62 and older find greater financial security in retirement. With this type of loan, you can access around 50-70% of your home’s value, with the exact amount depending on a range of factors related to your unique financial situation.
The funds can provide a powerful financial solution for older adults adjusting to a limited or fixed income in retirement. And, a major benefit is that you can continue to live in your home without making regular monthly mortgage payments, as long as you keep current with property taxes, homeowners insurance, and property maintenance. In fact, the loan only becomes due upon a qualifying event, such as once the you, or the final borrower, permanently leaves the home.
Another benefit of reverse mortgages is that by using the funds to cover your expenses, you can actually lower your taxable income. Because the loan proceeds are income tax-free,1 using them to cover your expenditures means you can avoid taking taxable withdrawals from retirement plans or your 401(k). So, not only are you reducing your taxable income, but you’re also preserving your retirement accounts!
Ways to Receive Your Funds
There are three main ways that you may opt to receive your funds, making the loan a flexible solution that can adapt to fit your goals.2 The first distribution method is a lump sum, where you can receive all your loan proceeds at once in a single payout. Although the available amount may be lower overall compared to other methods, it is still a popular option for borrowers who need access to a large amount upfront for a desired purpose.
The second distribution method is a monthly payout where you receive a predetermined amount of money each month to boost your regular cash flow. This is a good option for borrowers who value a steady stream of funds and prioritize managing expenses on a consistent basis.
The third option is the most versatile: a line of credit. This distribution method allows you to draw some funds upfront while leaving a portion available for the future. Because you only pay interest and fees on the funds that you withdraw, the unused portion may continue to grow over time,3 making this an ideal option for those who predict a need for cash in the future or value having a financing option in place for the unexpected.
In addition to these three options, you can also opt to receive funds via a combination of these methods. For instance, certain borrowers choose a blend of a lump sum payment and a line of credit. This enables them to initially settle an existing mortgage or merge other debts, and subsequently create a credit line for future expenditures.
Putting Your Cash to Work
As noted previously, using income-tax free1 cash from a reverse mortgage can allow you to delay withdrawing funds from your retirement account(s). But what can you actually use the money for? The short answer is, anything you’d like!
Some borrowers choose to consolidate high-interest debt, which may include existing mortgages or credit card balances. Another popular option is simply using the cash to fund everyday living expenses such as groceries, car payments, subscriptions, or other regular expenditures.
For others, it makes sense to preserve and allocate cash as savings for potential costs down the line. This may mean establishing savings for seemingly ever-increasing healthcare costs, setting aside funds for future travel plans or grandkids’ college tuition, or simply creating a rainy-day fund.
Simply put, there are virtually endless ways to use the funds from a reverse mortgage. And it’s all about putting the right plan together that makes sense for you and your own personal goals!
Now that we’ve covered the basics of a reverse mortgage, let’s dive into a few of the tax implications.
What Do You Need to Know for the Upcoming Tax Season?
Though the funds you receive from your reverse mortgage are income-tax free,1 there are a few other tax-related concepts that have to do with reverse mortgages. We always recommend you reach out to a trusted tax professional for a full discussion of how a reverse mortgage could impact your taxes, but it can be helpful to have an idea of the basics beforehand. With this in mind, here are some things to keep in mind as Tax Day approaches:
- Some of the costs from a reverse mortgage are tax deductible. Similarly to a traditional “forward” mortgage, a few of the associated costs can be claimed as deductible. These include reverse mortgage interest payments, origination fees, and broker fees. It’s important to note that reverse mortgage interest can only be deducted if the funds were used for substantial home improvement projects or buying/building a home. If the proceeds are used for one of these things, then you may deduct the interest upon paying off the loan.4
- You may receive a Form 1098 (mortgage interest statement) depending on your loan payment. If your payments on your mortgage interest top $600, your lender will be required to send you a Form 1098. If you are unsure about whether this form applies to you, or have questions about claiming the deduction, you should get in touch with your lender or tax professional directly.
- There can be impacts on your government benefits. The IRS does not qualify reverse mortgage payments as income, so benefits such as Social Security and Medicare will not be affected. In contrast, loan proceeds are considered an asset for needs-based benefits such as Medicaid, so if you don’t spend the loan payment in the month that you receive it you may risk becoming disqualified.4 We recommend consulting your financial advisor or the applicable government agency to understand the potential impact on different government benefits.
- You may owe capital gains taxes depending on your loan balance. Capital gains taxes are typically taxes on the profit of the sale of an asset. With reverse mortgages, a borrower or their heir cannot owe more than the value of the home at the time of its sale. This means that if the loan balance is greater than the home’s sale price, the difference is forgiven and funds from the sale are used to pay off the balance. However, the difference will still be taxed as additional sale proceeds.4
Putting it All Together
There are a few key takeaways for the upcoming tax season: reverse mortgage funds are not considered income and are therefore income-tax free,1 but you should get to know the cases in which the associated costs are tax deductible, or situations in which you may owe taxes related to your reverse mortgage funds. Although filing taxes can get complicated, working directly with trusted tax professionals, government agencies, and your lender can help ease your stress and make the process simpler.
One of the many benefits of a reverse mortgage is having access to funds that won’t increase your income tax burden.1 For older homeowners, utilizing financial tools to give yourself a strong financial footing can allow you to live your life to the fullest. Additional cash flow can help you prioritize your peace of mind and boost your financial stability throughout your well-deserved retirement years!
If you’d like to learn more about incorporating a reverse mortgage into your financial plan, the Longbridge team is here to help!
