Are Reverse Mortgages Taxable Income?

••• ColorBlind Images/Blend Images/Getty Images

A reverse mortgage is a loan available to homeowners 62 or older. Instead of the homeowner paying a lender, however, the lender gives the homeowner a monthly advance, a lump sum payment, a line of credit or some combination of these options. For several reasons, tax consequences among them, the Financial Industry Regulatory Authority advises that these mortgages be approached with caution.

How Reverse Mortgages Work

A reverse mortgage allows elderly homeowners to access the equity in their property. Although classified as a home equity loan, it must also be a first mortgage. From the proceeds of this loan, the lender pays off any existing mortgage debt, then makes the remaining funds available to the homeowner.

A reverse mortgage become due when the house is sold or the homeowner leaves the property. If the sale proceeds don't cover the loan payoff, the mortgage insurance required for most reverse mortgages covers the shortfall. Any proceeds of the sale in excess of the amount owed are paid to the homeowner or the estate.

Proceeds Are Tax Free

One positive aspect of a reverse mortgage is that the homeowner pays no taxes on any money received. This is appropriate because there is no taxable gain -- the reverse mortgage is a loan. Because reverse mortgage payments are not income, they don't affect income-related aspects of Social Security or Medicare benefits.

Other Tax Consequences

Although interest accrues monthly on reverse mortgages, it can't be deducted until it is actually paid -- almost always when the house is sold. This means that the homeowner loses one of the unique benefits of homeownership, which is that interest paid on home mortgages -- subject to certain limits -- is tax deductible each year over the life of the mortgage. This is a substantial tax disadvantage and is one of the reasons that FINRA suggests that homeowners first investigate other loan alternatives, including a conventional home-equity loan.

Another downside to reverse mortgages is that since the government classifies them as home equity loans, they are subject to the same deductibility limits of other home equity loans. Interest is only deductible on loan amounts up to $100,000. If the house has benefited from sufficient appreciation, another alternative to a reverse mortgage is simply to refinance with another larger first mortgage, usually with better loan terms and lower refinancing expenses.

Reverse Mortgages and Heirs

One good thing about a reverse mortgage is that it is a non-recourse loan. If the sale of the house doesn't generate enough money to pay off the loan, the heirs have no obligation to make up the difference. This remains true even if the deceased has other assets, which are shielded from the reverse mortgage debt. However, lenders charge higher rates and fees for non-recourse loans than for other mortgages.

A reverse mortgage can provide a tax advantage to a homeowner and his heirs because the home's tax basis is stepped up to the fair market value of the house at the time of the homeowner's death. A reverse mortgage that allows the homeowner sufficient funds to remain in his house until death allows the heirs to escape any capital gains tax otherwise due on the appreciated value of the house. This exemption is subject to the current Internal Revenue Service estate value limitations.