Are reverse mortgage proceeds income?
By James Veale
Jim: In last month’s column my wife, Marilu, and I explained how Home Equity Conversion Mortgages (HECM) or reverse mortgages work. Marilu, will you please summarize what we talked about. Marilu: I will be happy to quickly summarize some aspects of HECMs, but there is much more to learn about them than we have space here. HECMs are FHA insured reverse mortgages. FHA is part of the U.S. Department of Housing and Urban Development (HUD). To be eligible borrowers must be 62 years old or older and own their principal residence. Most homes are eligible. Generally the older the youngest borrower is, the lower the interest rate, and the greater the value of the home (up to $625,500), the more the proceeds that are available to borrowers. Although it is wrong to call reverse mortgage proceeds income. Jim: That’s right. For several years, I have been very active in a drive to clean up false advertising in our industry. Many readers have seen the direct marketing mailers that describe reverse mortgage proceeds as income or “tax-free income.” These are regrettable and should be stopped. In 2006 well meaning lawmakers created a body of law in California to provide more protections for reverse mortgage borrowers. An important part of that law was a disclosure informing seniors that in obtaining a reverse mortgage they should consider seeking the advice of family members and trusted advisors. Unfortunately the legislative consultant who wrote the disclosure used the term “additional income” to describe reverse mortgage proceeds. Using this unfortunate error as their excuse, less ethical originators continue their barrage of inaccurate but enticing advertising, labeling loan proceeds as income or tax-free income. Marilu: But that just recently changed. Jim: Correct. After meeting with California State Senator Alan Lowenthal in 2007, legislation slowly began being drafted to upgrade the disclosure and other parts of the California reverse mortgage law. Last October, the Governor signed into law a much improved version to the reverse mortgage law that, among other things, purges out all references to reverse mortgage proceeds as income. The law including the improved disclosure went into effect on January 1, 2010. No longer will less ethical lenders and originators be able to hide behind the California law when describing reverse mortgage proceeds as income. Marilu: Jim, will you please explain to our readers why reverse mortgage proceeds are not income or “tax-free income.” Jim: The bottom line is that income is generally a source of cash that people receive for their labor or goods sold. Sometimes it is earned through investment. However, one of its primary characteristics is that it does not have to be repaid. The proceeds of a reverse mortgage are debt that must be repaid when the mortgage matures. Interest accrues on the proceeds and so does FHA MIP (mortgage insurance premiums). Financed upfront costs must also be repaid. So not only must this so called “income” be repaid, it must be repaid with interest and other costs. What kind of income is that? The answer is that it is not income at all. It is debt that some marketers intentionally and deliberately try to disguise as income. This practice needs to be stopped. Generally, when borrowers pay back the balance due on a mortgage, the entire transaction is tax-free. To keep the home, the entire balance due must always be paid in full. However, if the balance due is greater than the value of the home, the excess can be forgiven or cancelled through foreclosure or short sale. The amount forgiven is additional taxable sales proceeds for income tax purposes. Because it is possible that some proceeds could be taxable, the Federal Trade Commission now prohibits the use of the term “tax-free income” in reverse mortgage advertising. If you have further questions, please feel free to call Marilu or me at (800) 620-0065.
