Frequently called home equity conversion mortgages (HECM) after the government-insured variant of the program, reverse mortgages let senior citizens pull money out of their houses without having to make payments. While a reverse mortgage puts money in their pockets, it's not considered income, so it's technically tax-free. On the other hand, it also means that their heirs will end up losing value to the interest and principal that build up against the home's equity.
Reverse Mortgage Basics
In a reverse mortgage, a lender allows a homeowner to either take a monthly amount or a lump sum out of their house. Instead of the homeowner having to make mortgage payments, the interest gets added on to the mortgage balance that accrues against the home's value. When the homeowner dies, his estate either pays off the mortgage with other money, or sells the house and uses the proceeds to pay off the HECM. The reverse mortgage lender is generally barred from evicting the homeowner from the house while he or she is alive, no matter how long he lives and how much interest builds up.
Is It Income
Just because the homeowner gets money out of a reverse mortgage doesn't mean he's getting income. When he takes out a reverse mortgage and gets $100,000, he's also going $100,000 into debt. The money and the debt cancel each other out so, from the Internal Revenue Service's perspective, he hasn't earned any income.
HECM and Estates
A reverse mortgage can have a benefit for a homeowner whose estate is large enough to trigger the estate tax. Taking out the reverse mortgage gives him money to spend now, before he dies. When he dies, the value of his estate will be diminished by the amount of the HECM's balance. This shelters it from estate taxes. However, given that as of 2013 an estate can exclude up to $5.25 million from taxes anyway, this benefit won't help many people.
Types of Reverse Mortgage
Reverse mortgages come in three types, all of which are tax-free. A single-purpose reverse mortgage is usually backed by a local government or non-profit organization and helps seniors with limited income get money for specific reasons, like repairs. These loans typically offer the best rates. Federally insured HECMs come from the U.S. Department of Housing and Urban Development and are easy to get but have relatively high upfront costs. Proprietary reverse mortgages are made by private organizations. Like HECMs, you can use them for just about anything, but they can also be expensive.
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