House rich but cash poor? Consider a reverse mortgage strategy

Are you an older taxpayer who owns a house that has appreciated greatly? At the same time, you may need income. Thankfully, there could be a solution with a tax-saving bonus. It involves taking out a reverse mortgage.

Reverse mortgage basics

With a reverse mortgage, the borrower doesn’t make payments to the lender to pay down the mortgage principal over time. Instead, the reverse happens. The lender makes payments to you and the mortgage principal gets bigger over time. Interest accrues on the reverse mortgage and is added to the loan balance. But you typically don’t have to repay anything until you permanently move out of the home or pass away.

You can receive reverse mortgage proceeds as a lump sum, in installments over a period of time or as line-of-credit withdrawals. So, with a reverse mortgage, you can stay in your home while converting some of the equity into much-needed cash. In contrast, if you sell your highly appreciated residence to raise cash, it could involve relocating and a big tax bill.

Most reverse mortgages are so-called home equity conversion mortgages, or HECMs, which are insured by the federal government. You must be at least 62 years old to be eligible. For 2024, the maximum amount you can borrow with an HECM is a whopping $1,141,825. However, the maximum you can actually borrow depends on the value of your home, your age and the amount of any existing mortgage debt against the property. Reverse mortgage interest rates can be fixed or variable depending on the deal. Interest rates can be higher than for regular home loans, but not a lot higher.

Basis step-up and reverse mortgage to the rescue

An unwelcome side effect of owning a highly appreciated home is that selling your property may trigger a taxable gain well in excess of the federal home sale gain exclusion tax break. The exclusion is up to $250,000 for unmarried individuals ($500,000 for married couples filing jointly). The tax bill from a really big gain can be painful, especially if you live in a state with a personal income tax. If you sell, you lose all the tax money.

Fortunately, taking out a reverse mortgage on your property instead of selling it can help you avoid this tax bill. Plus, you can raise needed cash and take advantage of the tax-saving basis “step-up” rule.

How the basis step-up works. The federal income tax basis of an appreciated capital gain asset owned by a person who dies, including a personal residence, is stepped up to fair market value (FMV) as of the date of the owner’s death.

If your home value stays about the same between your date of death and the date of sale by your heirs, there will be little or no taxable gain — because the sales proceeds will be fully offset (or nearly so) by the stepped-up basis.

The reverse mortgage angle. Holding on to a highly appreciated residence until death can save a ton of taxes thanks to the basis step-up rule. But if you need cash and a place to live, taking out a reverse mortgage may be the answer. The reason is payments to the lender don’t need to be made until you move out or pass away. At that time, the property can be sold and the reverse mortgage balance paid off from the sales proceeds. Any remaining proceeds can go to you or your estate. Meanwhile, you stay in your home.

Consider the options

If you need cash, it has to come from somewhere. If it comes from selling your highly appreciated home, the cost could be a big tax bill. Plus, you must move somewhere. In contrast, if you can raise the cash you need by taking out a reverse mortgage, the only costs are the fees and interest charges. If those are a fraction of the taxes that you could permanently avoid by staying in your home and benefitting from the basis step-up rule, a reverse mortgage may be a tax-smart solution.

© 2024

LEGAL DISCLAIMER: The information presented on this blog should not be construed as legal, tax, accounting or any other professional advice or service.  You should consult with a professional advisor familiar with your particular factual situation for advice concerning specific tax or other matters before making any decision.