In a reverse mortgage, interest is added to the loan balance and the total -- loan amount and interest -- is paid off after the home owner passes away or moves permanently out of the house. The homeowner does not get an interest deduction while the interest is accumulating. When the loan is eventually paid off, at least a portion of the interest charge will be deductible.
No Payments Means No Deductions
With a reverse mortgage, the homeowner receives the loan amount in the form of a lump sum, regular payments or access to a line of credit. The homeowner does not make any payments to repay the borrowed money or any interest that accrues to the outstanding balance. Since in most cases payments towards the reverse mortgage interest are not paid while the home is occupied, the interest cannot be deducted. If the homeowner makes voluntary payments towards the interest, the payments may be deductible under other rules governing home loan interest deductions.
Equity Loan Deduction Limitations
In most cases, the money received from a reverse mortgage will be classified as a home equity loan under tax rules. With home equity debt, the interest on up to $100,000 of the initial loan amount is tax deductible. For example, if a homeowner took out a $200,000 reverse mortgage, when the loan is finally paid off the accrued interest on $100,000 of the loan can be deducted. The remaining interest would not be deductible.
Claim on Estate Tax Return
Any deduction on the interest from a home equity loan usually will be paid after the home has been sold, when the entire loan balance is paid off. If the sale was due to the death of the homeowner, the deduction will be claimed on the estate tax return of the deceased. If the home was sold so the owner can move somewhere else, the deduction can be claimed on the owner's personal tax return for the year when the reverse mortgage gets paid off.
Additional Potential Deductions
The interest on mortgage loans used to purchase a home -- and any refinancing of that debt -- offers the traditional home mortgage interest deduction, with interest on up to $1 million claimable on a tax return. Reverse mortgage interest on any portion of the proceeds used to pay off acquisition debt will be tax-deductible. Also, if any reverse mortgage proceeds are used to substantially improve the home, the interest on the money spent to pay for home additions will be deductible. The $100,000 equity loan interest deduction could be added on top of any reverse mortgage money that qualifies as acquisition debt.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.