The money isn’t subject to income tax because it’s a loan advance, not income. The lender will eventually get the money back. But there can be some other tax implications when obtaining a reverse mortgage.
Reverse Mortgage Income Isn’t Taxed
You can take payment from a reverse mortgage in a few ways: in a lump sum, in incremental payments, or in combination. However you choose to take it, the money isn’t taxable because it’s not income, as mentioned. It’s the equity in your home converted to cash. The IRS calls the money “loan proceeds.”
How Reverse Mortgages Affect Government Benefits
These mortgages are only available to homeowners who are age 62 or older. The fact that the money is not considered income by the IRS can play a part if you’re receiving certain government benefits, as many seniors do. As non-income, the loan proceeds generally won’t affect your Medicare or Social Security benefits because these programs aren’t needs-based. You can take monthly reverse mortgage payments to bolster your Social Security payments and cover your budget. But Medicaid can be a different story because this program is “means-tested,” and it has more than one qualifying tier. One test measures your income, and another is based on the value of your financial resources. Again, the mortgage proceeds aren’t considered income, so you’ll avoid this requirement. But any reverse mortgage proceeds you have sitting in a bank account can disqualify you. You’re permitted only $2,000 in countable assets if you’re single, although some states allow for more. You could be eligible for up to $4,000 if you’re married and both you and your spouse are applying. You would have to spend down any money over this amount in the month you receive it to qualify for Medicaid.
How to Deduct Reverse Mortgage Interest
As for the interest accruing on your loan, mortgage interest is tax-deductible; reverse mortgage interest can qualify, but there’s a catch: You can’t claim the deduction until the loan is paid off for whatever reason, and you might miss out on the deduction entirely, depending on how you spend the reverse mortgage proceeds.
Interest Must Be Paid
Remember, interest is accruing monthly on your reverse mortgage, but you’re not making any mortgage payments toward it. An IRS rule for claiming the mortgage interest deduction is that the interest has to have been paid to qualify. You can’t deduct accruing interest that you still owe. Therefore, your interest would not be deductible until you pay off the reverse mortgage loan.
How You Spend the Money
How you spend your reverse-mortgage proceeds can affect deductibility of the interest as well. The IRS limits this deduction to loans where the money is used to “buy, build, or substantially improve” your home. You’d be ineligible for a deduction if you use the money to cover day-to-day expenses or to take that cruise you’ve been waiting for all your life, because a reverse mortgage is considered to be a home equity loan. It’s not a traditional mortgage.
You Must Itemize Your Deductions
The mortgage interest deduction is an itemized deduction. You must itemize on Schedule A and submit the schedule with your Form 1040 tax return when you file. You can’t claim the standard deduction for your filing status if you elect to itemize, so this could mean paying tax on more income than you have to if the total of all your itemized deductions doesn’t exceed the standard deduction you’re entitled to for the year.
Other Taxable Situations With Reverse Mortgages
Taking out a reverse mortgage won’t spare you from paying property taxes. You still hold title to your home, so your county or municipal authority will continue to assess property taxes against you personally, not your lender. And not paying them could effectively result in foreclosure. Your lender may call the entire reverse mortgage balance due. Your home’s equity secures your loan, and your lender won’t want to lose that collateral to your local taxing authority if you don’t pay. Capital gains tax may come due as well if you or your heirs should sell the home to pay off the mortgage. You could owe capital gains tax on the difference between what you initially paid for and invested into the property and the amount of the sale. But that amount would have to be rather significant before a capital gains tax kicks in. The IRS offers a home-sales exclusion if you owned and used your home as your primary residence for at least two of the last five years. You can realize up to $250,000 in gains as of 2022 without paying a tax if you’re single, or $500,000 if you’re married and file a joint tax return with your spouse. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
