Strategic Tax Planning with Reverse Mortgages
The Tax Cuts and Jobs Act of 2017 (TCJA) brought significant changes to tax laws in the United States. Among its impacts, it reshaped how mortgage interest deductions work, making reverse mortgages a more powerful tool for strategic financial planning, especially regarding retirement accounts like IRAs, Roth conversions, Net Unrealized Appreciation (NUA), and other tax-related strategies.
One major change under the TCJA was the substantial increase in the standard deduction for couples, now set at $24,000, and even higher for those over 65. This means that the vast majority of taxpayers, estimated at over 95%, will opt for the standard deduction instead of itemizing their deductions, regardless of homeownership status or mortgage situation.
Additionally, the TCJA limited mortgage interest deductions to acquisition indebtedness only. Previously, interest on home equity indebtedness up to $100,000 could be deducted, including on loans like HELOCs or second mortgages. Now, for interest to be deductible, the mortgage funds must be used to build, buy, or significantly improve the home.
Understanding the dynamics of a Home Equity Conversion Mortgage Line of Credit (HECM LOC) is crucial in this context. With a reverse mortgage, the line of credit grows over time as interest accrues on the borrowed amount. Payments made are first applied to Mortgage Insurance Premiums (MIP) and interest before reducing the principal balance. Any payment made increases the available borrowing capacity on the line of credit.
For tax planning purposes, consider a scenario where a client purchases a $600,000 home with a $300,000 reverse mortgage. After years of accruing interest, the loan balance increases to $360,000. At this point, the client can strategically withdraw $60,000 from their IRA, triggering taxable income. They then make a $60,000 voluntary interest payment on their reverse mortgage, potentially deductible as mortgage interest on their taxes.
By utilizing this strategy, the client can exceed the standard deduction threshold, possibly allowing for additional deductions such as medical expenses, charitable contributions, and real estate taxes. The client retains liquidity by increasing their borrowing capacity on the line of credit, providing access to tax-free distributions.
This approach can be repeated throughout retirement, leveraging the reverse mortgage to offset IRA distributions and maximize tax benefits. However, it’s essential to consult with a CPA or tax attorney due to the complexities involved.
Beyond these strategies, reverse mortgages offer further tax-saving opportunities. For instance, unpaid interest on a reverse mortgage can be deducted by heirs to offset income from an inherited IRA, particularly relevant under the SECURE Act’s accelerated distribution requirements.
Moreover, in the current low-tax environment, there’s potential for tax rate arbitrage by using a reverse mortgage to fund taxes on Roth conversions. Reverse mortgage proceeds can also be used to accelerate payment of taxes on Net Unrealized Appreciation (NUA) from company stocks.
Overall, reverse mortgages, with their flexible lines of credit and tax advantages, offer significant benefits compared to traditional mortgages. Despite higher closing costs and negative amortization, the tax savings and increased net worth often outweigh the costs, providing a net benefit to clients.
