Reverse Mortgage Taxes
Questions related to Reverse Mortgage Taxes.
Question: If my home of 25 years is mortgage-free and I get a reverse mortgage, then none of my interest will be acquisition indebtedness? My deductible interest will be limited to $100,000 of home equity indebtedness? (Assume no documented home improvements)
Answer: As to the first question and based on the factual setting presented, none of the interest would ever be deductible as interest related to acquisition indebtedness. None of the proceeds will be spent to 1) acquire a principal residence or qualifying second home or 2) substantially improve a principal residence or qualifying second home.
Your second question cannot be easily answered without additional information; therefore, this answer must be limited to one containing generalities or an answer based on specific assumptions. Because of the anticipated size of an answer presenting generalities, the following response is based on assumptions.
For purposes of responding to your question, let us assume that 1) the borrower must use the cash method of tax accounting to claim itemized deductions; 2) all proceeds used to date were spent solely on personal items such as food, medical, cars, car repairs, vacations, clothes, furniture, appliances, gifts, and other similar items; and 3) none of the proceeds were spent to finance investments, rentals (or other passive activities), or nonpassive activities, such as trade or business activities where the borrower is an active participant. Under these assumptions some (or all) of the interest would qualify as home equity indebtedness interest; however, the deduction in any one tax year would be limited to 1) the interest related to $100,000 of the related debt and 2) the amount of interest paid during the tax year. Any accrued interest qualifying as home equity indebtedness interest not paid in one tax year would be deductible in a subsequent tax year [in the tax year(s) paid]. Any interest not classified as interest related to home equity indebtedness would be classified as personal (or consumer) interest and such is not deductible.
Interest related to home equity indebtedness is not deductible for alternative minimum tax purposes. Based on the information provided and the assumptions being used, none of the interest accruing on the reverse mortgage would ever be deductible for alternative minimum tax purposes. Further complicating the interest rules is that even the otherwise deductible interest on acquisition indebtedness can be limited for alternative minimum tax purposes (no interest related to second homes and different restrictions on eligible types of homes).
Since the question does not address heirs, the answer has also ignored them. Other matters not addressed include: 1) financial institution application rules impacting Forms 1098, 2) allocating interest deductions between different types of interest when less than the entire interest accrued on the loan during the tax year is paid, and 3) the classification of interest accruing on interest when the loan exceeds $100,000. The response also ignores deductibility of interest when some or all of the proceeds are used to finance investments, businesses, rentals, or similar activities. The response has limited application and should be viewed in that way.
Because of so many potential benefits, complications, and determinations, a borrower should seek the advice of a competent and experienced tax advisor as early in the reverse mortgage process as possible. In some cases, IRS elections with specific deadlines may be required.
Question: Is MIP deductible? Initial and monthly?
Answer: Before 2007, the answer is generally no. However, if the loan proceeds were used in a business activity, in the same ratio that the interest was deductible business interest to total interest, the related MIP could be treated as a cost of the loan and amortized as a business deduction (other loan costs) over the life of the loan (although this is mere opinion, not settled law).
For the tax year 2007 and only 2007, limited amounts of mortgage insurance premiums are deductible for taxpayers with adjusted gross income of $100,000 ($50,000 for married filing separately) or less. The deduction phases out for taxpayers with adjusted gross income between $100,000 and $110,000 ($50,000 and $55,000 for married filing separately). No deduction is available to taxpayers with adjusted gross income in excess of $109,999 ($54,999, married filing separately).
To be eligible, the mortgage insurance contract must be issued after 2006. The new law treats mortgage insurance premiums as interest in the same ratio that proceeds are used to acquire a principal residence or second qualifying home or used to substantially improve such homes to loan proceeds. Thus for most HECM borrowers little if any of the MIP will be eligible for deduction as interest.
If a borrower is eligible to deduct MIP, then clearly to the extent deductible, monthly MIP is deductible during 2007. It is not clear whether the upfront MIP is deductible or not.
For example, say the MIP and origination fees on a loan are each $7,000. The proceeds on the HECM were used solely for improvements on the borrower’s principal residence. Let’s say the house was appraised at $350,000 and the county limit is $362,790. Further the principal limit is $249,200. Under income tax law for the origination fees to be deductible, they must meet certain rules, one of which is that the points (HECM origination fees and upfront MIP) must meet a percentage of the loan proceeds test. Neither the origination fees nor the upfront MIP seem to meet that test. Unfortunately, the IRS has not provided specific guidance on this issue.
If borrowers have any questions about the amount of MIP or type of MIP (upfront or monthly) they can deduct, they should seek the advice of a competent and experienced tax professional.
