I think a large portion of my posts begin with some variation of the phrase, “There is a great deal of confusion surrounding aspect xx of reverse mortgages.” While this certainly speaks to a lack of originality in my part, let’s face it, reverse mortgages are complicated. There are a lot of aspects which seem superficially similar to conventional mortgages, but are actually quite different. Reverse mortgage interest is one such aspect.
It’s not the the calculation of reverse mortgage interest which is complicated. Just like any other loan, interest is calculated on the outstanding balance of the loan. Whether you take the proceeds from a reverse mortgage as an upfront payment or in installments, interest charges will be calculated monthly based primarily on the amount of money that has been withdrawn to date. However, since you aren’t expect to make payments (interest or otherwise) to the lender with a reverse mortgage during the life of the loan, the loan balance will actually increase over time, such that you are not only paying interest on the principal, but also on the accrued interest. In this sense, a reverse mortgage can be thought of as a kind of negatively amortizing mortgage.
When it comes to the issue of tax deductibility, things get a little hairy. Unlike a conventional mortgage, the accrued interest associated with a reverse mortgage is not tax-deductible on an annual basis. Thus, while you can write off all (in most cases) of the interest on your conventional mortgage when you file your taxes every April, you can’t include interest on your reverse mortgage.
Instead, reverse mortgage interest can only be deducted when the loan matures. According to the IRS, “Because reverse mortgages are considered loan advances and not income, the amount you receive is not taxable. Any interest (including original issue discount) accrued on a reverse mortgage is not deductible until you actually pay it, which is usually when you pay off the loan in full.” Thus, the IRS feels that since it has been kind enough not to tax you on the proceeds you receive under your reverse mortgage, borrowers then don’t have any grounds for complaint when it comes to not being able to deduct the interest.
If you drill even deeper, however, into the abyss that is the US tax code, you will learn that IRS treats reverse mortgage proceeds as home equity debt, rather than conventional mortgage debt. While this distinction might sound trivial, it actually has serious implications. That’s because the IRS limits the amount of tax-deductible home equity debt to $100,000. Interest on any proceeds that you receive(d) in excess of that threshold, cannot be deducted.
It gets even more complicated when you consider that reverse mortgages are ultimately repaid not by the borrower (assuming he has passed away when the loan “matures”), but by his heirs. This introduces estate tax issues into the equation. Unfortunately, this is beyond my personal expertise, and anyone who ultimately wishes to minimize the tax burden associated with the repayment of a reverse mortgage is encouraged to consult a tax specialist. A financial planner might also be able to make some suggestions about some of the products (insurance and otherwise) which are designed to similar ends.