Tax-Smart Cash Flow Solution for Seniors with Appreciated Homes

Many older people own hugely appreciated homes but are short of cash. A side effect of large appreciation is the fact that selling the property to raise cash will trigger a gain well in excess of the federal home sale gain exclusion (up to $500,000 for joint-filing couples and up to $250,000 for unmarried individuals). The federal and state income tax bills could easily reach into the hundreds of thousands of dollars, and all that money would be gone forever.

Thankfully, there’s a potential solution that involves taking out a reverse mortgage on your property instead of selling. That way, you can take advantage of the tax-saving basis step-up rules explained below.

Basis Step-Up Rule to the Rescue

If you continue to own your residence until you or your spouse’s death, the result could be a greatly reduced or maybe even completely eliminated federal income tax bill when the property is eventually sold. This taxpayer-friendly outcome is thanks to Section 1014(a) of the Internal Revenue Code which generally allows an unlimited federal income tax basis step-up for appreciated capital gain assets owned by a person who passes away.

Under this rule, the income tax basis of most appreciated capital gain assets, including personal residences, are stepped up to fair market value (FMV) as of the date of death (or the alternate valuation date six months later, if applicable). When the value of an asset eligible for this favorable rule stays about the same between the date of death and the date of sale by the decedent’s heirs, there will be little or no taxable gain to report to the IRS — because the sales proceeds will be fully offset (or nearly so) by the stepped-up basis. Good!

How the Basis Step-Up Rule Works with a Residence

Here’s how the basis step-up rule plays out in the context of a greatly appreciated personal residence.

If you are married and your spouse predeceases you, the basis of the portion of the home owned by your departed mate, typically 50%, gets stepped up to FMV. This usually removes half of the appreciation that has occurred over the years from the federal income tax rolls. So far, so good. If you then continue to own the home until you pass away, the basis of the part you own at that point, which will usually be 100%, gets stepped up to FMV as of the date of your death. So your heirs can then sell the property and owe little or nothing to the U.S. Treasury.

Of course, if you’re unmarried and own the home by yourself, the tax results are easier to understand. The basis of the entire property gets stepped up to FMV when you pass on, and your heirs can then sell the residence and owe little or nothing to Uncle Sam.

Special Basis Step-Up Rule in Community Property States

If you and your spouse own your home as community property, the tax basis of the entire residence is generally stepped up to FMV when the first spouse dies (not just the 50% portion that was owned by the now-deceased spouse). This weird-but-true rule means the surviving spouse can then sell and owe little or nothing to the government.

In other words, if you turn out to be the surviving spouse, you need not hang onto the property until death to reap the full tax-saving advantage of the basis step-up rule. But if you want to hang on, there’s no tax disadvantage to doing so.

The Reverse Mortgage Strategy

As you can see, holding onto a hugely appreciated residence until death can save a ton of taxes thanks to the basis step-up rule. However if you need cash right now to keep going, we have not yet solved that part of the equation. Enter the reverse mortgage.

Reverse Mortgage Basics: When you take out a regular home loan, you must make monthly principal and interest payments to the lender. With a reverse mortgage, the lender makes one or more payments to you, the borrower. No payments to the lender are required until a triggering event occurs — such as when you move out or die. Meanwhile, the accrued interest builds up, and the loan balance gets larger rather than smaller. That’s why it’s called a reverse mortgage!

Taking out a reverse mortgage can give an older homeowner access to needed cash without selling the property. In fact, many seniors won’t qualify for a conventional “forward” home equity loan or home equity line of credit because they lack the requisite income. If you fit into this category, taking out a reverse mortgage may be the only way to convert some of your home equity into cash without selling and taking a big tax hit.

You can receive reverse mortgage proceeds as a lump sum, in installments over a period of months or years, or as line-of-credit withdrawals when you need cash.

These days, most reverse mortgages are home equity conversion mortgages, or HECMs, which are insured by the federal government. You must be at least 62 years old to qualify. The maximum amount that can be borrowed under an HECM is $625,500. The exact lending limit depends on the value of your home, your age, and the amount of any other mortgage debt against the property. To give you an idea, a 65-year-old can usually borrow about 25% of his or her home equity. The percentage rises to about 40% if you’re 75 and to about 60% if you’re 85.

Interest rates can be fixed or variable depending on the deal you sign up for. Rates are somewhat higher than for regular home loans, but not a lot higher.

As we stated earlier, a reverse mortgage does not require any payments to the lender until you move out of your home or die. At that time, the property is usually sold, and the reverse mortgage balance is paid off out of the sales proceeds. Any remaining proceeds go to you or your estate.

Reverse Mortgage Fees

Fees to take out and maintain a reverse mortgage will usually be considerably higher than for a regular “forward” home equity loan or line of credit. With an HECM, you will usually pay an origination fee equal to 2% of the first $200,000 of your home’s value plus 1 percent of any value above $200,000. However, the origination fee cannot exceed $6,000.

You will also be charged a first-year FHA mortgage insurance premium (MIP) equal to either 0.5% or 2.5%, depending on the terms of the loan. Over the life of the loan, you annual MIP premiums will equal 1.25% of the loan balance.

In addition, the lender can charge a monthly servicing fee of $30 to 35. Typically, you will also get socked with the familiar third-party home mortgage closing costs for things like title insurance, an appraisal, settlement services, and so forth. All these amounts are tacked onto the reverse mortgage balance.

Keep in mind: The reverse mortgage market is evolving. You’ll need to do some research to find the best product for your specific circumstances.

Deducting Reverse Mortgage Interest

The first $100,000 of reverse mortgage principal will often qualify as home equity indebtedness under the federal income tax rules. If so, you can claim an itemized deduction for the related interest expense because it will meet the definition of qualified residence interest.

In general, however, no interest deduction is allowed for alternative minimum tax (AMT) purposes unless you use the reverse mortgage proceeds to acquire, construct, or improve a first or second home. You would not typically use reverse mortgage proceeds for those purposes.

In any case, you can’t deduct reverse mortgage interest until you actually pay it in cash (assuming you’re a cash-basis taxpayer). Because reverse mortgage interest is just added to the loan principal, no payment of interest actually occurs until the loan is paid off. That may be many years down the road. For this reason, reverse mortgage interest usually doesn’t deliver much of a tax benefit. However, as explained earlier, hanging onto your greatly appreciated home until death could save a ton in taxes.

The Bottom Line

You might object to the notion of borrowing against your home to solve a cash flow problem. Fair enough, but the cash you need must come from somewhere. If it comes from selling your hugely appreciated home, the cost of getting your hands on the money will be a big tax bill.

In contrast, if you can get the cash you need by taking out a reverse mortgage, the only cost will be the fees and interest charges. If those fees and interest charges are a small percentage of the taxes that you could permanently avoid by continuing to own your home, the reverse mortgage strategy may make perfect sense.