Sale-leaseback may offer more benefits than reverse mortgage.

It is not unusual for an elderly client to find that he has a large amount of cash invested in his personal residence. For example, some fairly wealthy clients have between 60% and 70% of their net worth tied up in their homes. Very often, this cash may be needed to supplement the resident's income in later years. In response to this need, financial institutions and mortgage companies in 1980 began offering "reverse mortgages." However, because demand far outstrips supply, elderly residents often pay a steep price for the access to cash that reverse mortgages provide. A more beneficial alternative may be to structure a sale-leaseback of the residence between an elderly resident and his children.

Reverse mortgages

A reverse mortgage is an arrangement in which a home owner is allowed to borrow against the equity in his home and to periodically receive the loan proceeds (minus the interest). Generally, the reverse mortgage is for a fixed term of between five and 10 years. Some lenders also offer a lifetime reverse mortgage, provided the lender is given between 50% and 100% of any future appreciation on the property.

Because the proceeds of a reverse mortgage constitute borrowed funds, they are not subject to income tax. If the loan is secured by a qualified residence, the interest should be deductible under Sec. 163 when paid in cash. If the interest is deducted by the lender from the amount paid to the borrower or if the interest is added to the amount owed, the borrower generally is not entitled to the deduction until the debt ultimately is paid. (See Battelstein, 611 F2d 1033 (5th Cir. 1980), rehearing en banc, cert. denied; and IRS Letter Ruling 8324003.) Therefore, in most cases, deduction of the interest will be postponed until the reverse mortgage arrangement is terminated. If the arrangement is not terminated until after the resident's death, the deduction may not be used.

Because the elderly resident continues to own the home, its full value must be included in the decedent's estate when he dies (Sec. 2031). However, any amounts payable to the lender will be deductible under Sec. 2053 for estate tax purposes. The amount deductible should include any shared appreciation that must be paid to the lender (IRS Letter Ruling 9026041). The interest will be deductible (to the extent not deductible during the reverse mortgage term because it was not "paid") for income tax purposes as expenses in respect of a decedent under Sec. 691(b)(1), subject to the limitation of Sec. 163.

Sale-leaseback alternative

One alternative to the reverse mortgage arrangement is a sale-leaseback of the residence to family members. Under this arrangement, the senior family member sells the residence to his children and/or grandchildren or to a partnership in which the children and/or grandchildren are partners, and leases back the residence at a fair market rental rate.

If certain tests are met (i.e., the taxpayer has attained the age of 55 and the residence has been owned and used by the seller as his principal residence for three of the last five years), up to $125,000 of gain on the sale generally can be excluded from the seller's gross income under Sec. 121. However, the annual rental payments are not deductible (Sec. 262).

Although the purchasers are taxed on any rental income, they will be entitled to deduct depreciation, interest, maintenance and repairs, taxes and any other bona fide expenses related to the rental, subject to the passive loss limitations of Sec. 469. In addition, the purchaser receives a basis in the home equal to its purchase price (Sec. 1012).

Generally, a sale-leaseback arrangement will be more beneficial when the entire family is considered as one economic unit. Moreover, a sale-leaseback may offer more flexibility since the parties engaged in the transaction have similar goals. In making comparisons, it also should be considered whether the residence will be sold immediately following the lease term. The benefits of a sale-leaseback will be reduced by any income tax generated on a sale of the residence at the end of the lease term - especially when the value of the residence significantly increases after the initial sale or when a large amount of depreciation is incurred. See the example on page 361.

Example: Benefits of a Sale-Leaseback Over a Reverse Mortgage

Father, F, age 70, owns a residence valued at $325,000 with a basis of $200,000. F needs an additional $7,000 per year for personal expenses. F can obtain an 8.5% fixed-rate reverse mortgage from a local mortgage company for up to 80% of the value of the home (i.e., $260,000). Under the reverse mortgage arrangement, accrued interest from the previous year will be deducted directly from the cash loaned to F. In addition, the mortgage company is entitled to receive up to 80% (based on a percentage of the value loaned) of the property's appreciation between the initiation of the reverse mortgage and its complete repayment. At the beginning of each year, F will receive $7,000 cash on which no income tax must be paid. Also, F can continue to live in the residence rent free.

On the other hand, F could sell the residence for its current fair market value to a partnership in which his three children are partners and lease the residence back for a fair market rental, determined to be $12,000 per year. If F can invest the $325,000 proceeds at an 8.5% before-tax rate (5.865% after tax), he will have $7,061 of cash after the payment of income tax on the earnings and the annual rental expense. If F dies after 10 years and the home appreciates at a rate of 4% each year, the sale-leaseback will yield $62,218 more in savings than a reverse mortgage.