Tapping the equity of older homeowners with reverse mortgages.

The numbers certainly are impressive. Americans age 65 years and older now total 32 million. Of these, three-quarters own their own homes, and nearly two-thirds of them own their homes free of any mortgage. Total home equity of older Americans approaches $700 billion, representing a tremendous financial resource. But recent surveys show 86% of older homeowners want to remain in their homes for life. As a result, more Americans are asking their CPAs the same question: How can we tap some of this equity without leaving the home we love? This article considers one available option-the reverse mortgage.

KEY FEATURES

With reverse mortgages, owners borrow against the equity in their residences and defer repayment until some time in the future. Beyond this simple description, reverse mortgages vary widely in their key features depending on state law and local practice. Loan duration, borrower eligibility, repayment schedule, interest rate, size of loan and disclosure requirements all are important variables. (See the sidebar on page 39 for a description of some of them.)

Some uniformity may result, however, from the recent Federal Housing Administration (FHA) announcement of a tenfold expansion of its reverse mortgage program. This program's features are of particular interest to practitioners because of the program's national scope.

In general terms, FHA-insured reverse mortgages are available to people who are at least 62 years old and live in single-family dwellings that comply with local building codes. The amount that can be borrowed depends on the home's value, the borrower's age, prevailing interest rates and local housing cost averages. Many rural areas, for example, have a maximum loan amount of $67,500, while in other areas the FHA will lend up to $124,875 (1992 limits).

FHA mortgages, moreover, are of the life tenure type; that is, borrowers need not repay the loan until they die or move out of their mortgaged residences (perhaps to nursing homes). This feature contrasts with the more conventional fixed-term arrangement, under which monthly payments are sent to homeowners for a stipulated period of time and the total of those payments, plus interest, are due at the end of the period.

The life tenure concept obviously is more attractive to older homeowners because it speaks directly to the biggest emotional obstacle to tapping their homes' equity--a fear of outliving this equity and being forced to leave their homes before they are ready to do so. Clients who choose this option typically receive smaller monthly payments than those with fixed-term mortgages, but they have the security of knowing they will not be dispossessed.

INCOME TAX CONSIDERATIONS

At first glance, reverse mortgages seem to generate few tax considerations. The loan proceeds are not taxable, regardless of the payout schedule. Nor is the interest deductible by most homeowners, who typically report on the cash basis and accordingly have no deductions until the entire loan is repaid. Even then, interest is deductible only as home equity indebtedness to the extent the loan's principal does not exceed $100,000. Many reverse mortgages exceed that threshold.

The major income tax issue involves the $125,000 exclusion of gain on principal residences sold by homeowners at least 55 years of age. This is the same group that generally is eligible under the various reverse mortgage programs. The gain exclusion, of course, is familiar to most CPAs, particularly tax practitioners.

Although both reverse mortgages and the tax exclusion require minimum ages for eligibility, the tax exclusion also has an explicit home-use requirement. This requirement generally is three of the last five years, with an exception added in 1988 that counts time spent in a licensed nursing home toward the three-year requirement.

As a practical matter, homeowners who do not satisfy the usage test probably have little home equity to borrow against. But there may be circumstances in which an older person recently bought a home and paid cash for most or all of the purchase price. In that case, the homeowner is eligible for a reverse mortgage (age permitting), even though he or she is precluded from using the tax exclusion. The point remains, however, that the two provisions are not coterminous.

The tax exclusion is a one-time option. Moreover, a homeowner might be ineligible even for that one-time election if his or her spouse elected the exclusion previously, either singly or jointly with a prior spouse. Reverse mortgage programs, in contrast, look to the property's equity value rather than the borrower's life history. As long as sufficient collateral value remains in the property, a reverse mortgage may be obtained regardless of the property's previous mortgage history.

The tax exclusion and reverse mortgages, in other words, are very different phenomena. How then does a reverse mortgage affect the tax exclusion? Because a reverse mortgage does not affect the taxpayer's basis in the home, a subsequent sale will generate the same recognized gain an unencumbered home would produce. Nevertheless, the duration of a reverse mortgage may affect complete utilization of the $125,000 exclusion.

For a fixed-term reverse mortgage, sale of the home at the end of the term (to repay the loan) would trigger gain recognition. This applies even though the homeowner walks away from the transaction with little or no cash in hand.

For example, assume Ms. Homeowner obtained an $80,000 (payoff cost) reverse mortgage on her home five years ago when it was worth $100,000. It is now worth $120,000. Her historical cost basis is $35,000. Sales proceeds minus a 6% commission should yield $112,800, less her $35,000 basis, for a realized gain of $77,800. Yet, the actual cash received is only $32,800 (proceeds of $112,800 less the $80,000 loan repayment). Of course, Ms. Homeowner may be able to shelter this gain via the tax exclusion, but this is a one-time option and the excess of the $125,000 potential exclusion over the $77,800 of realized gain ($47,200) is lost forever. The reverse mortgage, in other words, may compel use of the tax exclusion before Ms. Homeowner would otherwise have elected it.

A life tenure reverse mortgage might produce the same result. Life tenure mortgages are due on the homeowner's death or the cessation of his or her use of the home as principal residence, whichever happens first. Ms. Homeowner, for example, might find after five years that her medical and general condition require institutionalization. Her departure from the house would cause the loan to become due, with the same tax consequences described above.

On the other hand, if death precedes departure from the house, the entire gain will be sheltered from income tax by the step-up-in-basis rule in Internal Revenue Code section 1014(a). That exclusion applies without dollar limitation, so there is no taxable gain under this scenario. This best of all possible worlds gives homeowners liquidity during their lifetimes, uninterrupted use of their residences while alive, and no taxable gain on disposition after death. This arrangement also follows older homeowners' wishes to remain in their homes.

The major problem that can arise in this situation, namely a medically necessitated departure from the home before death, is unfortunately the same event that can trigger less-than-favorable tax consequences. For homeowners with less than $125,000 of potential gain, an unanticipated predeath disposition might waste some of the exclusion otherwise available. For homeowners with more than $125,000 of potential gain or those not eligible for the tax exclusion (due perhaps to a prior election or that of a spouse), such a disposition triggers recognition of gain that otherwise would be sheltered by the step-up-in-basis rule at death.

In either situation, tax considerations represent a major downside risk of reverse mortgages. These mortgages remove from homeowners' control the critical ability to time disposition of their appreciated residences. As a consequence, the likelihood of being compelled to leave one's home for medical reasons always must be considered, however difficult it may be to ascertain.

LONG-TERM CARE CONSIDERATIONS

It also is important to focus on another implication of older homeowners' having to leave their reverse mortgaged homes before death--how to finance extended care outside the home. Contrary to the impression of many older Americans, long-term care (LTC) in a nursing home or similar setting usually is not covered by federally funded Medicare or by so-called Medi-gap insurance obtained privately. LTC insurance is available, but it is a product very much in its infancy and even younger in terms of its public acceptance.

Who pays the bill? The surprising answer for more and more Americans is Medicaid, the joint federal-state program for the poor. LTC needs of $35,000 per year and higher may turn once-solvent clients into impoverished applicants. The question then becomes: How do reverse mortgages fit into the Medicaid benefits eligibility criteria?

Two very different patterns emerge, depending on marital status. If homeowners are single or widowed, Medicaid programs generally require applicants to use virtually all financial resources, including their homes, before obtaining benefits. In such circumstances, a reverse mortgage is largely irrelevant. Their homes generally must be sold and the proceeds expended. There are some exceptions to this, but they are limited.

For example, a home may be given to a minor child, a child of any age who is blind or disabled, a co-owning sibling who also lives in the home or a child who lived in the home during the previous two years and took care of the owner during that time. Otherwise, the home must be sold and the proceeds used to pay LTC costs. A reverse mortgage that generated funds still on hand does not really alter this requirement, as those funds also must be used. Only a minimal $2,000 allowance may be retained.

If homeowners are married and have noninstitutionalized spouses, a reverse mortgage can make a major difference. Although specific limits vary from state to state, a stay-at-home spouse may generally keep no more than $70,740 (in 1993), plus the principal residence itself. Since cash and investment assets are limited while the home is not, the planner should consider maximizing the home's value.

Reverse mortgages, or any other debts for that matter, do just the opposite: They reduce the net equity in the home while potentially increasing the available funds state Medicaid laws restrict. Indeed, aggressive planners might suggest the opposite of a reverse mortgage--cash in excess of the $70,740 limit could be used to pay off residential indebtedness, make needed repairs and undertake appropriate improvements. But at the very least, such strategists probably would advise not encumbering the principal residence with a reverse mortgage or similar arrangement.

Preneed planning for LTC is only now emerging. It is far from clear what practitioners should advise and how much they should even consider the issue at all. It is naive, however, to contemplate securing a reverse mortgage without noting the curious incentives (some might say distortions) state and federal statutes provide.

A NATIONALLY UNIFORM PRODUCT

Although reverse mortgages have been around for 15 years, recent federal initiatives are expanding their availability and marketability. As a result, a nationally uniform product is now emerging that many lenders may feel comfortable providing. The resultant increase in awareness of these instruments and their various nuances compels CPAs to be conversant with their possibilities and planning implications. Tax consequences and emotional considerations also play a part in deciding which older home-owning clients will be well served by this developing option and which will not.

EXECUTIVE SUMMARY

* OLDER AMERICANS HAVE nearly $700 billion of equity in their homes. Since most prefer to remain in these homes for life, a reverse mortgage can enable them to tap the equity and still keep their homes.

* REVERSE MORTGAGES ALLOW owners to borrow against the equity in their homes and defer repayment until some time in the future. Federal and state law control loan duration, borrower eligibility, repayment schedule, interest rate and loan size.

* MOST REVERSE MORTGAGES are either of the life tenure or fixed-term variety. Life tenure mortgages are not repaid until the borrower dies or moves out of the mortgaged residence. Fixed-term mortgages involve monthly payments to the homeowner for a fixed period, with interest and principal due at the end of that time.

* TAX CONSIDERATIONS, particularly the $125,000 gain exclusion for homeowners at least 55 years old, are important in deciding if a reverse mortgage is appropriate. A reverse mortgage could force a sale at a time when the homeowner might suffer adverse income tax consequences.

* HOME OWNERSHIP ALSO is a factor in financing long-term care. Medicaid requires single homeowners to use virtually all financial resources, including their homes. A married homeowner whose spouse is in a nursing home can retain the residence and other assets, subject to certain limits. Reverse mortgages may be inadvisable in such circumstances.

* REVERSE MORTGAGES ARE likely to become more popular as the Federal Housing Administration expands its national program.

FEATURES OF NON-FHA REVERSE MORTGAGES

Reverse mortgages are available in a variety of programs other than the Federal Housing Authority-insured version. Although specific features and limitations must be ascertained locally, some key variables include

1. Loan duration. In addition to the fixed-term and life tenure arrangements described in the article, some reverse mortgages are set up simply as lines of credit secured by a home's equity. This version enables the borrower to draw down funds as needed.

2. Minimum age of borrower. There is no uniformity among states. Some examples: Arizona and New York, age 60; California. age 65; Florida, age 70.

3. Interest rate. Some states cap the interest rate that may be charged. In California, however, lenders are allowed to compensate for this limitation by obtaining shared appreciation--an equity kicker that gives the lender a portion of any price appreciation in the underlying real estate.

4. Maximum loan amount. Some states impose loan ceilings expressed as a percentage (say, 80%) of net equity (current fair market value less any outstanding mortgage debt).

RICHARD L. KAPLAN, CPA, JD, is professor of law at the University of Illinois in Urbana-Champaign. He is a member of the National Academy of EIder Law Attorneys, the American Bar Association and the American Institute of CPAs national tax education program steering committee.