This article examines the conditions,requirements and limitations on de-ductions of the interest accrued on re-verse mortgage loans.1 Close to onemillion reverse mortgage loans arecurrently outstanding. As the 75 mil-lion members of the Baby Boomergeneration march into retirement overthe coming 15 years, the number ofreverse mortgage loans will likely in-crease significantly.2

Reverse mortgage loans accrue in-terest, generally over long periods. Be-cause essentially all of the borrowersare cash method taxpayers, that in-terest is not deductible until it is actu-ally paid. Payment is usually, but notalways, made when the home secur-ing the loan is sold. Other conditionsand requirements limit the obligor’sability to claim the deduction.

The deduction is lost if the home issold by a person (or entity) who (orthat) does not have sufficient income to

be offset by the deduction. As describedbelow in this article, the conventionalapproach for passing the borrower’shome equity to the heir(s) will generallyresult in the loss of the deduction. Theauthors suggest to estate planners andprobate attorneys a simple alternate ap-proach, connecting the deduction withincome, to take advantage of the de-duction. This approach can be usedmost often, but not exclusively, whenthe borrower has a defined contributionretirement account, such as a 401(k) ac-count or a rollover IRA.

Quantitative estimates of the rele-vant interest amounts and retirementaccount values, derived from MonteCarlo simulations, are provided in il-lustrative examples.

OVERVIEWMost people, including tax practition-ers, have only a limited understanding

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EDITED BY LOUIS S, WELLER, J.D.

REAL ESTATE r

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Recovering a LostDeduction

BARRY H. SACKS, NICHOLAS MANINGAS, SR., STEPHEN R. SACKS, AND FRANCIS VITAGLIANO

Although the conventional approach for passing a borrower’s home equityto heirs generally results in the loss of the deduction for reverse mortgageloan interest, the deduction may be used if it is connected with income,such as when the borrower has a 401(k) account or rollover IRA.

of reverse mortgages. Therefore, a sum-mary of the salient features of reversemortgages is provided in the Appendixat the end of the article. For purposesof this article, however, a reverse mort-gage is simply a loan secured by theborrower’s principal residence, themost relevant feature of which is thatrepayment is not required until theborrower permanently leaves the res-idence.3 A reverse mortgage loan canbe used in many different ways: Forexample, it can be used like a conven-tional purchase money mortgage loan,to pay a portion of the purchase priceof a new residence of the borrower; itcan also be used like a conventionalHELOC (Home Equity Line of Credit),drawn upon at the times, and in theamounts, that the borrower chooses,to be used for any purpose.

This article is focused on the de-ferred repayment and the interest thataccrues as a result of that deferral. Aslong as the repayment is deferred, theinterest accrues and compounds. Asnoted above, most individuals arecash method taxpayers, so the interestthat accrues is not deductible until itis actually paid. The concerns in thisarticle are about how much of thatinterest is deductible and by whom.

The particular use of the loan pro-ceeds determines the characterizationof the indebtedness. If the proceedsare used for acquisition or substantialimprovement of the residence, or torefinance an earlier loan that was usedfor that purpose,4 the indebtedness ischaracterized for tax purposes as “ac-quisition indebtedness” under Section163(h)(3)(B)(i). If, on the other hand,the loan is used for any other pur-pose, it is characterized as “home eq-uity indebtedness” under Section163(h)(3)(C)(i). The characterization, inturn, determines the conditions, re-quirements and limitations on the de-

ductibility of the accrued interestwhen it is actually paid.

The next section sets out the statu-tory and regulatory framework thatestablishes the conditions, require-ments, and limitations on the de-ductibility of the accrued interest. Afterthat, a couple of illustrative examplesof how reverse mortgages can be usedwith substantial benefit as part of re-tirement income planning are pro-vided. Next, tax analysis is applied tothe deduction of the interest deter-mined in those examples.

THE PROVISIONS OF THE CODE ANDREGULATIONS GOVERNINGTHE INTEREST DEDUCTIONSection 163(h) has a rather convo-luted structure, which provides that,in the case of an individual taxpayer,no deduction is allowed for “personalinterest,” and then specifies that per-sonal interest is any interest allowableas a deduction other than items listedunder subsection (h)(2). The itemslisted under subsection (h)(2) include“qualified residence interest.” “Qualfiedresidence interest,” in turn, is definedin subsection (h)(3) to be “any interestwhich is paid or accrued” on acquisi-tion indebtedness or home equity in-debtedness. A loan that refinances ac-quisition indebtedness is also treatedas acquisition indebtedness.

Acquisition IndebtednessSection 163(h)(3)(B)(i) defines “acqui-sition indebtedness” as “any indebt-edness which—(I) is incurred in ac-quiring, constructing, or substantiallyimproving any qualified residence ofthe taxpayer, and (II) is secured bysuch residence.”

Application in the Reverse MortgageContext. As pointed out in the Appen-

dix, reverse mortgages can be obtainedonly by borrowers who are 62 yearsof age or older. A reverse mortgage thatinvolves acquisition indebtedness is, inmost cases, incurred when a borroweruses the reverse mortgage for one ofthe following purposes: (1) to acquirea home5 that constitutes “downsizing”from a larger home, after children havegrown up and moved out, or that con-stitutes a move to a more “retirementfriendly” location; (2) to substantiallyremodel a current home to make itsafer or more comfortable for residentsas they age; or (3) to refinance an ear-lier mortgage loan taken to acquire,construct, or substantially improve thecurrent home, and thereby eliminatethe need to continue making paymentson the earlier mortgage loan.

The first of the two examples dis-cussed later in this article will illustratethe use of a reverse mortgage for ac-quisition of a downsized home for aretiree and the deduction of the inter-est accrued on such a reverse mort-gage.

Limit on Deductible Interest. Theamount of indebtedness that can betreated as acquisition indebtednesscannot exceed $1 million.6 Therefore,the amount of interest on acquisitionindebtedness cannot exceed the inter-est on $1 million. In the reverse mort-gage context, when the interest is gen-erally not paid until many years afterthe indebtedness is incurred, intereston acquisition indebtedness can growto a large figure. However, when in-terest grows and compounds, it is im-portant to ask whether interest on in-terest on acquisition indebtedness istreated as interest on acquisition in-debtedness. There does not appear tobe any authority that answers thisquestion, so the authors read thestatute very literally and take the con-servative position that the interest ac-crued on the interest on acquisitionindebtedness is home equity indebt-edness. This home equity indebted-ness itself will not be deductible, butinterest on it will be deductible, subjectto the limit on home equity indebt-edness, which is discussed directly be-low.7 As the illustration in footnote 7shows, this interest amount is trivial

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BaRRY H. SaCKS is a practicing tax attorney in San francisco, California. niCHoLaS ManinGaS, SR.is Manager-Reverse Mortgage Lendings, Gateway Mortgage Group LLC, Tri-State philadelphia Region.STEpHEn R, SaCKS is a professor emeritus of economics at the university of Connecticut in Storrs.fRanCiS ViTaGLiano is Visiting Scholar at Boston College Center for Retirement Research in Boston,Massachusetts. Copyright © 2016 Barry H. Sacks, nicholas Maningas, Sr., Stephen R. Sacks, and francisVitagliano. The authors wish to thank Shelley Giordano, Chair of the funding Longevity Task force,for continuing encouragement, support and information, all very helpful to their research in generaland to the preparation of this paper in particular. They also wish to thank James Veale, Cpa, for pro-viding valuable technical advice, and professor adam Chodorow for providing valuable editorial andtechnical advice.

in comparison with the simple intereston the acquisition indebtedness.

Accordingly, with regard to the in-terest on acquisition indebtedness,only the simple interest will be treatedas deductible.

Home Equity IndebtednessSection 163(h)(3)(C)(i) defines homeequity indebtedness as “any indebted-ness (other than acquisition indebted-ness) secured by a qualified residenceto the extent the aggregate amount ofsuch indebtedness does not exceed—(I) the fair market value of such qual-ified residence, reduced by (II) theamount of acquisition indebtednesswith respect to such residence.”

Application in the Reverse MortgageContext. Clearly, if a reverse mortgageis taken at a time when there is littleor none of the purchase money mort-gage remaining to be paid, the reversemortgage debt will not be “acquisitionindebtedness”; it will be “home equity

indebtedness.” Most often in this sit-uation the reverse mortgage will betaken in the form of a line of credit,with the proceeds used for the bor-rower’s personal living expenses. Re-cent scholarly and academic researchhas shown that a reverse mortgage

credit line, used in coordination witha securities portfolio, can be a very ef-fective mechanism to stabilize andeven enhance the retirement incomeof retirees whose primary source ofincome is the securities portfolio. (Theportfolio is typically, but not neces-sarily, held in a 401(k) account, arollover IRA, or some other definedcontribution account).8 The retireeswho can benefit to the greatest extentare the “mass affluent” retirees, de-scribed below. Further research is cur-rently being done on the use of re-verse mortgage credit lines to stabilizeand enhance the retirement incomeof retirees who have defined contri-bution accounts but are not in the“mass affluent” category.9

The second of the two examplesdiscussed later in this article will illus-trate the use of a reverse mortgagecredit line to stabilize and enhance re-tirement income drawn primarilyfrom a securities portfolio and the de-

duction of the interest accrued onsuch a reverse mortgage.

Limit on Deductible Interest. Theamount of indebtedness that can betreated as home equity indebtednessis $100,000.10 As noted above, the in-terest on the interest on acquisition

indebtedness is treated as home equityindebtedness, so that interest on thoseamounts can accrue and compoundeach year, until the total home equityindebtedness reaches $100,000. How-ever, only the interest on the homeequity indebtedness is deductible.

The Same Transaction Can GiveRise to Both Types of Indebtedness.Nothing in Section 163 states thatthere cannot be deductions for intereston both acquisition indebtedness andhome equity indebtedness secured bythe same property and incurred asparts of the same loan transaction. Infact, Rev. Rul. 2010-25, 2010-44 IRB571 specifically allows interest deduc-tions for interest both on acquisitionindebtedness and on home equity in-debtedness, secured by the same prop-erty and incurred as parts of the sametransaction. Therefore, the total interestthat can be deducted (subject to thelimitations described herein) is the

sum of the interest on the acquisitionIndebtedness plus the interest on thehome equity indebtedness.

Another LimitIn addition to the other limits de-scribed in this article, there is another

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Nothing in Section 163 states that there cannot bedeductions for interest on both acquisition indebtednessand home equity indebtedness secured by the sameproperty and incurred as parts of the same loantransaction.

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1 The reverse mortgages referred to in this article arethe Home Equity Conversion Mortgages (HECMs),which were created by Congress, are governed byHuD, and are insured by fHa. More than 95% of allreverse mortgages currently outstanding are HECMs.for more complete discussion of HECMs, see, e.g.,Giordano, What’s the Deal With Reverse Mortgages?(people Tested Media, 2015).

2 This increase is likely to occur as more retirees andtheir advisors recognize that home equity constitutesa substantial portion of many retirees’ wealth and thatit can be used effectively to enhance and stabilize re-tirement income, and also to achieve the retirees’other financial objectives set out below. See, e.g., state-ments by Robert C. Merton, nobel Laureate in eco-nomics, at the 2015 annual Conference at the MiTCenter for finance and policy (9/25/15) Seewww.youtube.com/watch?v=dpzLR__xLto.

3 although repayment of the loan is not required untilthe borrower permanently leaves the residence, re-

payment of any or all of the outstanding loan debt ispermitted at any time during the life of the loan.

4 a reverse mortgage used to pay part of the purchaseprice of a home is referred to, in the reverse mortgageindustry, as an “HECM for purchase.” The HECM forpurchase is specifically authorized by the Housingand Economic Recovery act of 2008 (“HERa”). See,also, HuD Mortgagee Letter 2008-33.

5 for brevity, the term “home” will be used in this articleto mean “principal residence.”

6 Section 163(h)(3)(B)(ii). 7 To illustrate, suppose that there is $250,000 of acqui-

sition indebtedness at the beginning of the first year.at 4%, there would be $10,000 of interest accrued atthe end of the first year. That $10,000 would be inter-est on acquisition indebtedness, and hence would bedeductible when actually paid. at the end of the sec-ond year, there would be another $10,000 of interestaccrued on the acquisition indebtedness plus $400

of interest accrued on the first $10,000 of interest.The $400 would be home equity indebtedness (butnot interest on home equity indebtedness). at the endof the third year, there would be an additional $800of interest accrued on the two $10,000 amounts plus$16 of interest on the $400 amount. The $16 wouldbe interest on home equity indebtedness, and hencewould be deductible when actually paid.

8 The research leading to this finding is amply de-scribed in the financial planning literature. See, e.g.,Sacks and Sacks, “Reversing the Conventional Wis-dom—using Housing Wealth to Supplement Retire-ment income,” 25 Journal of financial planning 43(february 2012). See, also, Salter, pfeiffer, and Evensky,“Standby Reverse Mortgages: a Risk ManagementTool for Retirement Distributions,” 25 Journal of finan-cial planning 40 (august 2012).

9 neuwirth, Sacks, and Sacks, research paper in prepa-ration.

10 Section 163(h)(3)(C)(ii).

NOTES

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limit on the deductible interest, whichapplies when the average debt balance(including both principal and interest)for the tax year exceeds the adjustedpurchase price of the home securingthe debt. In such case, the amount of“qualified residence interest,” the inter-est that is deductible, is defined byTemp. Regs. 1.163-10T(c) and (d) to beequal to “the total interest . . . multi-plied by a fraction . . . the numeratorof which is the adjusted purchaseprice . . . of the qualified residence andthe denominator of which is the . . .average balance of all secured debts.”It is not at all clear from the regulationwhether the term “total interest,”within the contemplation of this reg-ulation, means the total compoundinterest on the debt or only the com-pound interest up to the limits dis-cussed above plus the simple interestbeyond those limits.

In the context of a reverse mortgage,the average balance of the secured debtis likely to exceed the adjusted pur-chase price of the home only in thefollowing situations: (1) in the case ofacquisition indebtedness, many yearsfollowing the loan transaction, whenthe interest itself has grown to equalor exceed the initial loan principal; and(2) in the case of home equity indebt-edness, many years following the bor-rower’s purchase of the home, if theappreciation of the home has broughtthe fair market value, at the time theloan is taken, up to more than doublethe purchase price.

Issues Relating to the Alternative Minimum Tax.The interest on acquisition indebted-ness is deductible in computing the al-ternative minimum taxable (AMT) in-come, but the interest on home equityindebtedness is not. Thus, home equityindebtedness is doubly disadvantagedas compared with acquisition indebt-

edness: Not only is the amount ofhome equity indebtedness on whichthe interest is deductible against otherincome merely one-tenth as large asthe amount of acquisition indebted-ness on which the interest in de-ductible, but also the interest on homeequity indebtedness is not deductiblein computing the AMT income.11

Nonetheless, the accrued intereston the home equity indebtedness stillmight provide some economic benefitto the taxpayer. The benefit would bethe following: By bringing the “regu-lar” income tax down below the levelof the AMT, it brings the actual taxamount down to the AMT level,which, because of the AMT rate, is lessthan the regular tax would have beenwithout the deduction.

DEDUCTION CONSIDERATIONSWHEN THE BORROWER LEAVESTHE HOME BECAUSE OF DEATHBecause there is a greater likelihoodthat the deduction would be lostwhen the borrower leaves the homebecause of death than because of anyother reason, attention will first focuson how the heir(s) can benefit fromthe interest deduction.

When Can the Interest Be Deducted?Because most individual taxpayers arecash method taxpayers, the interestcan be deducted only when it is paid.Generally, the interest is paid when theborrower permanently leaves thehome, the home is sold, and the re-verse mortgage is paid off. Very oftenthis is by reason of death, and it is theheir of the borrower who can benefitfrom the deduction. Of course, how-ever, the reverse mortgage is also paidoff if the borrower permanently leavesthe home while still living, because heor she is no longer able, or no longerwilling, to continue living in the home.As discussed below, there are certainsituations in which the borrower him-self or herself might pay off some orall of the reverse mortgage loan andtake the interest deduction, either uponleaving the home or even, in rare cir-cumstances, while staying in the home.

Provision that Allows the Interest to Be Deductible by the Heir(s).The provision that allows the heir(s)to claim the interest deduction is Reg.1.691(b)-1, which reads, in relevantpart:

1.691(b)-1. Allowance of deductions andcredit in respect of decedents. — (a) Undersection 691(b), the . . . interest . . . describedin sections . . . 163 for which the decedent. . . was liable, which were not properlyallowable as a deduction in his last tax-able year or any prior taxable year, areallowed when paid — (1) As a deduction by the estate; or (2) If the estate was not liable to pay suchobligation, as a deduction by the personwho by bequest devise, or inheritancefrom the decedent acquires, subject tosuch obligation, an interest in propertyof the decent . . .”12

Close reading of the regulation in-dicates that some careful planning isnecessary. From a practical stand-point, what often happens is that theestate plan, or the estate or trust ad-ministration, does not treat “holisti-cally” the disposition of the decedent’shome (by means of a will or trust) inconjunction with the disposition ofthe decedent’s IRA or 401(k) account(by means of a beneficiary designa-tion). As a result, the executor or ad-ministrator of the estate, or the trusteeof the trust, gathers the decedent’s as-sets, liquidates them, and then distrib-utes the net proceeds to the heirs.These assets often include the home,but not the IRA or 401(k) account. Insuch situations, the estate or trust maynot have much (or any) taxable in-come, and hence, when the home issold by the estate or trust, and the re-verse mortgage debt is paid off, mostor all of the interest deduction is lost.

Notice that the language of the reg-ulation allows only the heir to havethe deduction “if the estate was not li-able to pay such obligation.” The typ-ical provisions for paying off the re-verse mortgage obligation followingthe death of the borrower allow theheirs, the executor, or the trustee ofthe borrower, to arrange for the dis-position of the home and pay the ob-ligation. Thus, the estate would be li-able to pay the obligation only if itarranges, and agrees, with the lenderto dispose of the home and make the

11 Sections 56(e) and (b)(1)(C)(i). 12 The applicable sections of the Code are Sections

691(b), 163(h), and 280a. Reading these sections, with-out going outside the Code, one could very well de-duce that the heir(s) of a borrower, to be able to claimthe deduction, would have to move into the bor-rower’s home, make it his or her (or their) “residence,”for at least 14 days and not engage in repair or main-tenance for at least 14 days.

NOTES

payment, and actually does disposeof the home and make the payment.13(Furthermore, because the debt isnon-recourse, it would not be rea-sonable for the estate to be liable forthe obligation if the home is passeddirectly, in kind, to the heir(s), subject

to the obligation.) There does notseem to be any way, in the scenarioin which the estate or trust sells thehome, that the estate or trust couldtransfer the unused portion of the in-terest deduction to one or more heirs,for use against their income in respectof a decedent (e.g., the IRA or 401(k)account) or against any other incomesuch heir(s) might have.14

The practical suggestion to estateplanners and probate attorneys, es-pecially those dealing with mass af-fluent retirees, is to be sure that, if allother things are equal, the arrange-ment is such that the interest deduc-tion can be best used, and not lost. Inmany (perhaps most) cases, the moststraightforward way to achieve thisresult is for the home to be transferredin kind to the heir(s) of the borrower.The heir(s) would then sell the homeand be entitled to the deduction. (Al-ternately, if one or more heirs want tocontinue to own the home, the re-verse mortgage debt could be refi-nanced with a conventional mortgage,and the refinancing would constitutethe payment that would entitle theheir to the deduction.) If the heir(s)’taxable income is less than theamount of the deduction availableand the heir(s) are also the benefici-ary(ies) of an IRA or 401(k) account

of the decedent, they could take a dis-tribution from such account to matchthe remaining amount of the deduc-tion. Otherwise, some or all of the de-duction would be lost.

It may be possible, under somestates’ probate laws, that the execu-

tor or administrator could choosewhether to sell the home or transferthe home in kind to the heirs. If thehome is held in a trust, standard trustprovisions generally allow a trusteeto decide whether or not to sell trustassets, so long as such decision is de-termined to be in the best interests ofthe trust beneficiaries.

DEDUCTION CONSIDERATIONSWHEN THE BORROWER LEAVESTHE HOME BEFORE DEATHThere are many situations in which aretired borrower would leave thehome before death, sell the home, andpay off the reverse mortgage. Obvi-ously, these situations include, but arenot limited to, those in which the bor-rower’s health no longer allows theborrower to live on his or her own,or where there is a desire to movecloser to adult children, or into a re-tirement community, etc. In the eventof such a sale, of course, the borrowerwould obtain the income tax deduc-tion himself or herself. The deductioncould, as noted above, be used againstany taxable income that the borrowermay have in that year. Also, as notedabove, there does not appear to beany way that the unused portion ofthe interest deduction can be carried

back or forward, like a net operatingloss. Because gain, if any, on the saleof the home is treated as capital gain,but only to the extent that it exceedsthe $250,000 or $500,000 exclusion setout in Section 121, there may not beenough taxable income to be offsetby the entire available deduction forthe accrued interest. If that is the case,and the borrower has an IRA or401(k) account, it may be beneficial todraw from the IRA or 401(k) accountwhatever amount can be offset by theuse any available interest deductionfrom the repayment of the reversemortgage. Alternatively, the borrowermight use the available interest de-duction to offset the tax on a Rothconversion of some or all of the IRAor 401(k) account.15

DEDUCTION CONSIDERATIONSWHEN THE BORROWER PAYSOFF SOME OR ALL OF THEREVERSE MORTGAGE DEBTWHILE STILL IN THE HOMEWhat about a borrower who wishesto pay off a part of the reverse mort-gage debt while still living in thehome? Consider a retired borrowerwho is receiving taxable income fromSocial Security and a rollover IRA,and also may have some after-tax ac-cumulated wealth. Suppose that theborrower has used a reverse mortgagecredit line, either to help purchase thehome (as in the first example below)or to augment his taxable income (asin the second example below), orboth. As a result of the reverse mort-gage, he has accrued some interest,perhaps a sizeable amount of interest.The borrower would now like to usesome of his taxable income, or someof his accumulated wealth, to paydown a portion of the reverse mort-gage debt,16 thereby obtaining an in-

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13 HuD Handbook, 4330.1, 13.33 and 13.34. The time al-lowed for such arrangements is initially three months,but can be extended up to 12 months, in three-monthincrements. See, also, standard HECM promissorynote, section 7(a).

14 a possible exception, but one that probably has lit-tle utility and certainly has little flexibility, comesfrom the provisions of Section 642(h)(2) and Regs.1.642(h)-2 and 1.642(h)-3. These provisions allow “ex-cess deductions” to be used by beneficiaries, but

only by those beneficiaries, and under only thosecircumstances, described in the regulations.

15 When the home is sold, any capital gain realized issubject to income tax, but, where applicable, the gainis also eligible for the $250,000 or $500,000 exclu-sion under Section 121. Because the reverse mort-gage debt is non-recourse, when the debt exceedsthe value of the home, the disposition is nonethelesstreated as a sale under Section 1001, and the fullamount of the debt is treated as the proceeds real-

ized. The fair market value of the home is irrelevant,and the cancellation of indebtedness provision ofSection 108 does not apply. Tufts, 461 uS. 300, 51afTR2d 83-1132(1983); iRS publication 4681, at p. 4;See, also, Geier, “Tufts and the Evolution of Debt Dis-charge Theory,” 1 fla. Tax Rev. 115 (December 1992)

16 as a practical matter, the reverse mortgage debtwould not be entirely paid off, but instead at least atoken amount, such as $100, would be left owing, sothat the credit line would not be closed.

NOTES

Those most benefitted by the uses ofthe reverse mortgage loans are the“mass affluent” retirees.

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come tax deduction for the interestportion of the amount used to makethe payment.17 He would immediatelyborrow back from the reverse mort-gage credit line the amount he hadpaid. He would then be in exactly thesame economic position, at least fromthe “cash in hand” standpoint and thetotal debt standpoint, as before thetransaction, except that his tax billwould be lower.18

Another way that the borrowercould proceed would be to borrowfrom a third-party lender the amountto pay down a portion of the reversemortgage debt, rather than use any ofhis income or accumulated wealth,and then make the payment, imme-diately borrow back from the reversemortgage credit line the amount pre-viously borrowed from the third-party lender, and re-pay the third-party lender. Again, at the end of thistransaction, he would be in exactlythe same economic position, at leastfrom the “cash in hand” standpointand the total debt standpoint, as be-fore the transaction, except that histax bill would be lower.

It seems quite clear that such atransaction, done either way, wouldnot survive scrutiny under the “eco-nomic substance doctrine.” The eco-nomic substance doctrine is a com-mon law doctrine that has beencodified as Section 7701(o). The codi-fied form of the doctrine applies to in-dividuals only if the transaction is“entered into in connection with atrade or business or an activity en-gaged in for the production of in-come.19 However, the statutory lan-guage provides a concise expressionof the doctrine, as follows:

[S]uch transaction shall be treated as hav-ing economic substance only if —

(A) the transaction changes in a mean-ingful way (apart from Federal incometax effects) the taxpayer’s economic po-sition, and (B) the taxpayer has a substantial purpose(apart from Federal income tax effects) forentering into such transaction.20

It is amply clear from that languagethat, because the transactions de-scribed do not change the taxpayer’seconomic position at all (apart fromlowering his federal income tax bill),the interest deduction would not beallowed under those transactions.

Suppose, instead, that the final stepin the set of steps described in the firstparagraph of this section is not taken.That is, the individual does not bor-row back from the reverse mortgagecredit line the amount he had paid. Inthat case, the individual is not in thesame economic position as he wasbefore the transaction. Economically,he has less cash and less debt. He hassimply paid down a portion of hisdebt, and that payment includes pay-ment of some interest, for which he isentitled to an income tax deduction.It happens to be a payment that he isnot obligated to make at that time; butthat fact does not seem relevant to theeconomic substance issue. However,what if he later borrows back a sim-ilar amount from the reverse mort-gage credit line? Does it matter howmuch later? Is there a subjective ques-tion about his intention at the earliertime to borrow later?

Consider another situation: Sup-pose that the same borrower as de-scribed above receives some sort ofeconomic windfall. If the windfall isnot subject to income tax (e.g., an in-heritance), the borrower might use themoney to pay off a portion of the re-verse mortgage debt, thereby benefit-ting from the interest deduction, to the

extent that the deduction is allowedunder the limitations and conditionsdescribed above. The borrower couldthen draw an equivalent amountfrom his IRA or 401(k) account, off-setting the taxable amount by theamount of the interest deduction. Hecould also use the income tax deduc-tion to reduce or eliminate the tax costof doing a Roth conversion of someor all of the IRA or the 401(k) account.

In this case, it seems that the bor-rower’s economic position has changedin a meaningful way. He has less in hisIRA or 401(k) account, and has in handthe amount by which his IRA or 401(k)is reduced. He no longer has theamount of the windfall, but that is off-set by the amount he has from his IRAor his 401(k) account. His debt on thereverse mortgage is reduced. With thosechanges in economic position, it is cer-tainly arguable that the transactionmeets the requirements of the eco-nomic substance doctrine.

One more situation, a rather obvi-ous one, in which the interest deduc-tion on a reverse mortgage can betaken by the borrower while still inthe home, is the following: Supposethe homeowner, who is 62 years old,or older, has a conventional mortgageon which he is making regular pay-ments. Suppose, further, that themortgage is acquisition indebtedness,or that the outstanding principal bal-ance is not greater than $100,000. Ifthe conventional mortgage is refi-nanced by a reverse mortgage, thehomeowner would have the flexibilityto continue to make the regular pay-ments, or to make interest-only pay-ments, or to make payments of anyamount, or to make no payments atall. Whenever a payment is made, tothe extent of the interest in the pay-ment, it is deductible.

WHO BENEFITS THE MOST AND WHAT ARE THEIR MAJORFINANCIAL OBJECTIVES?The financial planning literature showsthat the greater the ratio of home valueto the value of the retiree’s securitiesportfolio, the greater the beneficial effectof strategic coordination between these

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17 under typical reverse mortgage agreements, a por-tion of any repayment amount is the repayment ofthe accumulated “mortgage insurance premiums.”Currently, that portion is treated as interest to theextent that the mortgage itself is treated as acqui-sition indebtedness. Section 163(h)(3)(E). as of thiswriting, this Code section is effective through12/31/16. for further discussion, see, e.g., “Tax plan-ning and Reverse Mortgages: Deduction Bunchingand Loan payments,” blogs by Dr. Tom Davision attcbdavison.files.wordpress.com/.../tax-planning-with-a-reverse-mortgage and at toolsforretirementplanning.com/2014/04/18/reverse-mortgage-research/.

18 from the standpoint of the composition of the debt,i.e., the allocation between interest and principal, hewould be in a different position, one with more prin-cipal, and less interest, owed. as a result, his (or hisheir’s) future payment(s) might have different tax con-sequences than if the transaction had not occurred.Moreover, since the reverse mortgages consideredhere are generally subject to variable interest rates,the transaction considered does not constitute a re-financing and does not result in a different interestamounts charged or a different overall amount owed.

19 Section 7701(o)(B)(5). 20 Section 7701(o)(1).

NOTES

two assets in optimizing the retiree’scash flow (and other financial objec-tives) during the years in retirement. 21As a result of the limitation on theamount of home value that can beconsidered for a reverse mortgage, i.e.,$625,500, the “mass affluent”22 retirees(whose assets and financial objectivesare specified below) are those mostbenefitted, in financial terms, by the useof reverse mortgages during retirement.

The Mass Affluent RetireesThose most benefitted by the uses ofthe reverse mortgage loans, as de-scribed in the examples below, are themass affluent retirees. Typically, themass affluent have a net worth at re-tirement in the range of $1.5 millionto $3 million, well below the levelwhere estate tax is a consideration.

Most often, this wealth consistsprimarily of two assets: a securitiesportfolio (usually in a 401(k) accountor a rollover IRA); and a home, insome cases encumbered by little or nodebt, and in other cases encumberedby more debt than the retiree cancomfortably service. For most massaffluent retirees, these two assets havevalues that are of the same order ofmagnitude

Of the Baby Boomer generation’s75 million members, close to 15 mil-lion are in the mass affluent category.23

Major Financial ObjectivesThe major financial objectives of massaffluent retirees are: 1. Cash Flow Survival, i.e., not run-

ning out of money during retire-ment. (The risk of outliving one’smoney is often termed the “Lon-gevity Risk.”)

2. Retaining some financial cushionto be available in the event of fi-nancial emergency.

3. Passing something on to heirs andbeneficiaries. (This is often termedthe “Bequest Motive.”) Now turn to two examples, to il-

lustrate some transactions that use re-verse mortgages to advance these fi-nancial objectives, to illustrate thedetermination of the amount of inter-est that accrues as a result of thesetransactions, and to illustrate theamounts of accrued interest that aredeductible. In both examples, the re-tirees are typical “mass affluent” retirees.

FIRST ILLUSTRATIVE EXAMPLEThe first example begins with the fol-lowing scenario:

A 67-year-old retiree has a rolloverIRA worth $1 million, invested in atypical securities portfolio.24 He alsohas a home, with a value of $1.13 mil-lion, with an ordinary mortgage se-cured by the home, with a $500,000outstanding balance (thus, with equityof $630,000). The retiree wants to sellthe current home and downsize to anew home that will cost $850,000, buthe will have only $600,000 from thesale of his current home, after com-mission and closing costs. He willneed about $40,000 per year (inflationadjusted) plus Social Security, for liv-ing expenses (including income taxes),without needing any amount to serv-ice a mortgage.

Two Ways to ProceedThe retiree described in the openingscenario can proceed in either of twoways to obtain the additional $250,000needed to purchase the new home: 1. Withdraw from the IRA (reducing

it from $1,000,000 to $640,000, i.e.,$360,000 is withdrawn, of which$110,000 is used to pay the income

tax on the $360,000, leaving$250,000 for the home purchase).

2. Obtain a reverse mortgage loan for$250,00025For convenience, each of these two

ways to proceed will be termed a“transaction,” and more specifically,the first will be termed the “IRA Trans-action” and the second will be termedthe “Reverse Mortgage Transaction.”

Which Transaction Will Better Advance the Retiree’sThree Major Financial Objectives?Of the three major financial objectivesspecified above (cash flow survival,cushion for emergency, and making abequest), the first objective is generallyparamount. So the focus is on thatobjective first.

The graphs in Exhibits 2 and 3,generated by Monte Carlo simulation,show the probabilities of cash flowsurvival under each of the two trans-actions mentioned above.26 In each ofthese graphs, the lowest line showsthe probability of cash flow survival(as a function of the number of yearsfollowing the transaction) when theannual cash amount (in this example,$40,000, adjusted for inflation) isdrawn from the IRA alone. The uppertwo lines show the probability of cashflow survival when the annual cashamount is drawn from the IRA, butis augmented by draws on the reversemortgage credit line. The two upperlines show the results of using twodifferent augmentation strategies.Those two augmentation strategies areexamined in greater detail as part ofthe second illustrative example.27

The essential point, clear from thegraphs, is that the Reverse MortgageTransaction results in substantiallygreater cash flow survival probabilitythan the IRA Transaction.

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21 See, e.g., Sacks and Sacks, supra note 8. See also, Salter,pfeiffer, and Evensky, supra note 8. in the context ofthis literature, “optimizing” means balancing betweenmaximum amount of annual cash flow and minimumrisk of cash flow exhaustion, during retirement.

22 The term is somewhat misleading: it does not meanthat they are massively affluent. instead it means thatthere is a mass of them, and, in fact, they are betterdescribed as “almost affluent.” However, the term“mass affluent” has achieved a wide currency in thefinancial planning community and in its literature, so,

reluctantly, it is adopted here. (See, e.g., freedman,

Oversold and Underserved—A Financial Planner’s

Guidebook to Effectively Serving the Mass Affluent,

(fpa press, 2008.)

23 Study conducted by Metropolitan Life insurance

Company “Mature Market” division. private commu-

nication.

24 The portfolio in these examples is made up of six asset

classes, allocated in the proportions described in Ex-

hibit 1.

25 it is clear from the economics of this example thatservicing a conventional mortgage would severelyburden the retiree’s cash flow, leading to an early cashflow exhaustion.

26 The technique for developing these graphs, usingMonte Carlo simulation, is outside the scope of thisarticle, but is amply described in the financial planningliterature. See, e.g., Sacks and Sacks, supra note 8 andSalter et al supra note 8

27 The two augmentation strategies are described inSacks and Sacks, supra note 24.

NOTES

Next, the retiree’s other two finan-cial objectives are considered. Thesame Monte Carlo simulations thatwere used to generate Exhibits 2 and3 were also used to estimate theamount of financial cushion availableat any time during retirement (i.e., thevalue of the IRA at that time plus theamount available at that time from

the reverse mortgage credit line) andthe amount available for bequest (i.e.,the retiree’s overall net worth) at anytime. Because these are estimatesbased on Monte Carlo simulations,the longer the time that elapses be-tween the time of the transaction andthe time with respect to which the es-timate is made, the wider the disper-

sion of the results. The results areclear: The median amount of each ofthese figures at any time during re-tirement is substantially greater if theReverse Mortgage Transaction is usedthan if the IRA Transaction is used.

Because the Reverse MortgageTransaction yields better results for allthree of the retiree’s financial objec-tives than the IRA Transaction, thattransaction will be the focus to deter-mine the amount of interest that ac-crues as a result of the transaction,and to determine the conditions, re-quirements, and limitations on its de-ductibility.

Now determine the amount of in-terest that accrues as a result of the re-verse mortgage transaction, or at leastmake a reasonable estimate of thatamount. This estimate is relatively easyto make, given that the loan principalis all taken at the outset of the trans-action. Therefore, the problem that ex-ists when different amounts of theloan principal are taken at differenttimes is not present. The interest rate,however, is variable. For simplicity,however, assume that, on average, theinterest rate is somewhere between 4%and 8%. Therefore, Exhibit 4 containsa table of the interest accrued on the$250,000 loan amount at each of threeinterest rates, 4%, 6%, and 8%, for eachof five periods, 10 years, 15 years, 20years, 25 years, and 30 years from theoutset of the transaction.

In this example, the $250,000 bor-rowed by the retiree is clearly “acqui-sition indebtedness,” because it is usedto acquire the new home. As discussedabove, the interest on the acquisitionindebtedness accrues and compounds.However, the interest on that interestis treated as home equity indebtedness,and the compound interest on thathome equity indebtedness is trivial incomparison with the simple intereston the acquisition indebtedness, so itis ignored. In other words, only thesimple interest on the acquisition in-debtedness is considered.

The table in Exhibit 4 sets out theamounts of the simple interest on theacquisition indebtedness, in separatecolumns, for the three assumed inter-est rates, and for the five periods spec-

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Asset Classes and Allocation Used in Monte Carlo Simulations

EXHIBIT 1

asset Class

percentagein asset

allocation

Meaninvestment

Return*Standard

Deviation*

u.S. Large Cap Stocks 40% 8.50% 20.65%

u.S. Small Cap Stocks 10% 9.00% 25.00%

international Stocks 10% 8.00% 24.80%

Long Term Bonds 10% 4.50% 10.80%

intermediate Term Bonds 15% 4.75% 6.50%

u.S. Treasury 1 yr. ConstantMaturit

15% 4.30% 3.00%

Means and standard deviations based on projections used in “Money-Guidepro” financial planning software.

First Example: Probability of Cash-Flow Survival Using the IRA TransactionStrategy

The upper two lines reflect the use of the reverse mortgage credit line to augmentincome drawn from the securities portfolio (the retiree’s iRa), using the Coordinatedstrategy, and the Reverse Mortgage Last strategy, respectively, and the lowest linereflects income drawn from the portfolio only.

EXHIBIT 2

ified above. Clearly, because $250,000of acquisition indebtedness is lessthan $1 million, all the simple interestthat accrues on that amount is de-ductible (when paid).

As noted above, the actual interestrate is variable, and of course is im-possible to predict. Therefore, the im-portant thing to recognize is not theprecise amounts shown in the table,but the order of magnitude. For ex-ample, even after 15 years and at thelowest of the three assumed interestrates, the total simple interest accruedis $150,000. And after 20 years and atthe middle of the three assumed in-terest rates, the total simple interest accrued is $300,000. Accordingly, thetax planner should take the necessarysteps to assure that the deduction isnot lost.

There is one more item to considerbefore moving to the second example.That item returns to the three objec-tives described above in the sectionon deduction considerations whenthe borrower leaves the home beforedeath. Because the Reverse MortgageTransaction results in greater amountsin the IRA at any given time (thanwould be there at that time if the IRAtransaction were used), how muchwould be in the IRA at any time whenthe Reverse Mortgage Transaction isused? Why is that question asked? Be-cause the IRA could be the verysource of taxable income againstwhich the interest deduction could betaken.28 So, again running the MonteCarlo simulation, the median amountin the IRA is found at the end of eachof the five periods, 10, 15, 20, 25, and30 years from the outset of the trans-action. Those results are set out in thetable in Exhibit 5. Again, it is true thatthe longer the period, the greater thedispersion of the results of the simu-lation. To indicate the extent of thatdispersion, the “standard deviation”of each of the result is set out beneaththe median result.

Comparing the figures in Exhibits4 and 5 shows that there is a very highlikelihood that, if the retiree or his heirdoes not have sufficient other incomeagainst which to use the interest de-duction, there are ample amounts that

can be drawn from the IRA to takeadvantage of that deduction.

SECOND ILLUSTRATIVE EXAMPLEThe second illustrative example beginswith the following scenario:

A 67 year-old retiree has a rolloverIRA worth $700,000, invested in a typ-ical securities portfolio. She also hasa home, with a value $900,000, whichis owned free and clear (no debtagainst it). Unlike the retiree in the

previous example, this retiree plans tostay in the home. However, like theretiree in the preceding example, thisretiree will need about $40,000 peryear (inflation-adjusted) plus Social

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First Example: Probability of Cash-Flow Survival Using the ReverseMortgage Transaction Strategy

The upper two lines reflect the use of the reverse mortgage credit line to augmentincome drawn from the securities portfolio (the retiree’s iRa), using the Coordinatedstrategy and the Reverse Mortgage Last strategy, respectively, and the lowest linereflects income drawn from the portfolio only.

EXHIBIT 3

First Example: Interest on Acquisition Indebtedness

EXHIBIT 4

number of Years 4% 6% 8%

10 Years $100,000 $150,000 $200,000

15 Years $150,000 $225,000 $300,000

20 Years $200,000 $300,000 $400,000

25 Years $250,000 $375,000 $500,000

30 Years $300,000 $450,000 $600,000

This table shows the estimated amounts of interest accrued, at assumed averageinterest rates, under the Reverse Mortgage Transaction described in the firstExample

28 There is no requirement, for income tax purposes,that the iRa (or, indeed, any “income in respect of adecedent”) be the only income against which the in-terest deduction can be taken. However, the benefi-ciary’s other income might not be enough to offsetthe amount of interest that is deductible, and it doesnot appear that the interest deduction can be carriedback or forward like a net operating loss. So, taking adistribution from the inherited iRa may be the onlyway the beneficiary/heir can avoid losing some or allof the interest deduction.

NOTES

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APPENDIX: SALIENT FEATURES OF HECM REVERSE MORTGAGES

A reverse mortgage is a loan secured by the borrower’s principal residence (“home”). It is similar to a conventional mortgage, in that

the borrower still retains title to the home, and is still obligated to pay the property tax and homeowner’s insurance, and to maintain

the home. But there are some unique features, the most salient of which are set out below:

1. Age Requirement: HECMs are available only to borrowers 62 years of age or older. (If a married couple is the borrower and one

of spouses is below the age of 62 at the time the loan is taken, that spouse can be treated as a so-called “non-borrowing spouse”

(NBS). If the borrowing spouse predeceases the NBS, the NBS can remain in the home for as long as he or she chooses, but cannot

draw any further loan proceeds if the proceeds have not all been drawn. Also, in light of the fact that the NBS is younger than 62

at the time the loan is established, the amount available to borrow is actuarially reduced to reflect that age.

2. Loan Amount Available: The amount of loan available (the “principal limit”) is a function of the age of the youngest borrower,

the appraised value of the home, and the “expected” interest rate (the value of which is determined by HUD on the basis of the

LIBOR 10-year swap rate). The value of the home that is considered in determining the amount available is the lesser of the ap-

praised value or $625,500. At the current expected rate (as of January 2016) the typical loan amounts available are between ap-

proximately 40% of the considered home value (for borrowers in their early 60s) and approximately 65% of the considered home

value (for borrowers in their late 70s or early 80s). Thus, a 67-year-old borrower, with a home value of $625,500 or more, can

borrow approximately $350,000. After the loan is established, the amount available, to the extent not drawn, increases at the

same rate as the interest that applies to the amount actually drawn. To illustrate, if the borrower described above does not draw

on the loan until he reaches age 72, and average interest rate is 5% during the five-year period leading up to his reaching age 72,

the loan amount available at age 72 would be more than $450,000. (The line of credit established but not immediately drawn

upon is sometimes referred to as a “standby line of credit.”)

3. Ways in Which Loan Proceeds Can Be Received: The loan proceeds can be received in any of three ways, or in any combination

of the three ways: (a) as a lump sum at the outset, which may be all or any portion of the loan amount available; (b) as a line of

credit, which can be drawn upon in any amount, and at any time, until the amount available has been completely drawn down;

and (c) as a series of regular periodic payments, for a fixed number of periods or for the life of the borrower.

4. Interest Rates: Generally, the interest rates on reverse mortgages are variable. The exception is that a fixed interest rate can be

obtained when the entire available amount of the loan is taken at the outset of the loan. The annual interest rate is most often

the one-month LIBOR rate plus a “margin” (fixed at the outset of the loan) plus a “mortgage insurance premium” amount (generally

equal to 1.25% of the loan amount borrowed). The margin is usually in the range of 2% to 4%. The higher figure generally will be

chosen in exchange for a lower Origination Fee.

5. Set-Up Fee: The set-up fee for a HECM includes three components. One component is the Initial Mortgage Insurance Premium,”

which is equal to .5% of the appraised value of the home (up to a maximum of $625,500) if 60% or less of the amount available

is taken in the first year, or is equal to 2.5% of the appraised value of the home (up to a maximum of $625,500) if more than 60%

of the amount available is taken in the first year. The second component is the Origination Fee, which can be any amount in the

range of zero up to a maximum of $6,000. The amount can be negotiated, as noted in paragraph 4, with a lower Origination Fee

in exchange for a higher interest rate. The third component, sometimes called third party charges, include appraisal and survey

fees, title and title insurance fees, and credit checks. As a general rule of thumb, these cost $1000-$2000.

6. Must Be the Only Loan Secured by the Home: The reverse mortgage must be the only loan secured by the home. Thus, if there

is a conventional mortgage on the home, a reverse mortgage can be taken only if that conventional loan is first paid off. When

the conventional loan balance is relatively small compared to the amount of reverse mortgage loan available, a portion of the re-

verse mortgage proceeds is used to pay off that conventional loan, as part of the closing process. If the conventional loan balance

is slightly larger than the amount available from the reverse mortgage, the borrower may bring some of his own assets to the

closing to complete the transaction. The purpose of the reverse mortgage in such a situation would be to relieve the borrower of

any future obligation to make mortgage payments.

7. Borrower Cannot Be Evicted Except for Failure to Pay Property Tax or Homeowner’s Insurance, or Failure to Mantain the Home:

Despite residual reports left over from the early days of pre-HECM reverse mortgages, the borrower cannot be evicted from the

home for any reason, except for failure to pay the property tax, failure to maintain homeowner’s insurance, or failure to maintain

the home.

8. HECM Debt is Non-Recourse: HECM loans are non-recourse. Thus, neither the borrower nor his or her heirs can be responsible

to the lender for any greater amount of debt than 93% of the value of the home. (The 7% figure allows for the costs of sale.) There

are many issues, outside of the scope of this article, concerning the tax treatments resulting from the various dispositions of the

home when the debt exceeds the fair market value. See note 15 and sources cited therein

9. When Repayment is Due: Repayment of a HECM debt is due only after the borrower has permanently left the home. The typical

arrangement, as set out in the standard promissory note, is that the borrower, or the family or other representative of the borrower,

has three months (which can be extended in three-month increments to a total of 12 months) to arrange for the repayment.

Security, for living expenses (includingincome taxes).

Two Ways to ProceedAs in the previous example, there aretwo ways to proceed. In this example,the two ways to proceed are the fol-lowing: 1. The retiree could simply draw the

$40,000 per year (inflation-ad-justed) from the IRA, and only ifand when the IRA runs out ofmoney, she can draw from a re-verse mortgage credit line. (Thisway to proceed is a passive strat-egy, because it reflects a “wait andsee” attitude, a hope that the IRAwill not run out of money. It canalso be called the “Last Resort Strat-egy,” since it uses the reverse mort-gage loan to augment the retire-ment income only as a last resort.)

2. The retiree could proceed in a moreactive way by taking a reversemortgage credit line and using it toaugment her income in a “Coordi-nated Strategy.” The CoordinatedStrategy uses the reverse mortgagecredit line to fill in the troughs in

the volatility cycles of the securitiesportfolio in the IRA. More specifi-cally, the reverse mortgage creditline enables the retiree to not drawon the portfolio when it is “down,”thereby enabling a greater recoveryof value when it is in an “up” partof its volatility cycle. (This strategyis sometimes described as “offset-

ting the adverse sequence of re-turns.”) The algorithm used in the simula-

tion model of the Coordinated Strat-egy is straightforward: At the begin-ning of each year, the investmentperformance of the securities portfolioduring the previous year is deter-mined. If the previous year’s perform-

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First Example: Amounts in the IRA

EXHIBIT 5

number ofYears:

10 15 20 25 30

Median am’tin iRa:

$1,384,000 $1,565,000 $1,732,000 $1,966,000 $2,180,000

StandardDeviation:

$601,000 $1,015,000 $1,553,000 $2,317,000 $3,464,000

This table shows the median values of the amounts in the iRa, in the first Example, ifthe Reverse Mortgage Transaction is used, after the stated numbers of years. alsoshown are the “standard deviations” of those values. Moreover, the simulation showsthat the probability of there being more than $500,000 in the iRa at the end of eachperiod (except 30 years) is 85% or more. at the end of 30 years, the simulationshows that the probability is approximately 81%.

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168 r J o u R n a L o f T a x a T i o n l a p R i L 2 0 1 6 R E a L E S T a T E

ance was positive, the current year’sincome is drawn from the portfolio.If the previous year’s performancewas negative, the current year’s in-come is drawn from the reverse mort-gage credit line.29

Referring again to the first of thethree financial objectives of the retiree,

as set out above (i.e., cash flow sur-vival during retirement), the graph inExhibit 6 shows the probability ofcash flow survival, as a function ofthe number of years into retirement,for each of the two augmentationstrategies. It is clear that the Coordi-nated Strategy provides a substan-

tially greater probability of cash flowsurvival than the Last Resort Strategy.This graph, like those shown in Ex-hibits 2 and 3, was derived fromMonte Carlo simulation. In addition,the same simulation technique showsthat the retiree’s other two financialobjectives have greater probabilitiesof being achieved when the Coordi-nated Strategy is used than when theLast Resort Strategy is used.30

As in the First Example, the nextstep is the calculation of the amountof interest accrued under the strategythat best enables the retiree to meetthe three objectives, i.e., the Coordi-nated Strategy. In the Second Exam-ple, it is clear that the reverse mortgageloan is home equity indebtedness, andnot acquisition indebtedness. There-fore, the interest will compound untilthe total indebtedness reaches$100,000, and after that only simpleinterest will be added.

As in the First Example, the ac-crued interest will be determined, ateach of the three assumed rates, up tothe points in time that are 15, 20, 25,and 30 years from the outset of thetransaction. This task is a bit moresubtle than in the first example, be-cause in this example the draws onthe reverse mortgage credit line arenot all taken in the first year, and arenot all taken in any particular year. Infact, the years in which the draws aretaken cannot be predicted precisely;instead, using the Monte Carlo simu-lation model to estimate, the medianyear in which the total indebtednessreaches $100,000 is determined, andthen simple interest is computed fromthat year out to the 10th, 15th, 20th,25th, and 30th years from the outsetof the transaction. It turns out that,for each of the three assumed interestrates, the median year in the MonteCarlo simulation in which the cumu-lative indebtedness (including thedraws on the reverse mortgage creditline plus compound interest on thosedraws) has reached $100,000 is the 6thyear. It also turns out that the medianamount of the portion of that$100,000 that is the cumulative drawon the credit line, and thus is not in-terest, is about $85,000. That means

Second Example: Interest on Home Equity Indebtedness

EXHIBIT 7

number of Years 4% 6% 8%

10 Years $31,000 $39,000 $47,000

15 Years $51,000 $69,000 $87,000

20 Years $71,000 $99,000 $127,000

25 Years $91,000 $129,000 $167,000

30 Years $111,000 $159,000 $207,000

This table shows the estimated interest on the home equity indebtedness in theSecond Example, resulting from use of the Coordinated Strategy for drawing on thereverse mortgage credit line to augment the income from the iRa.

Second Example: Probability of Cash-Flow Survival Using the TwoStrategies

EXHIBIT 6

29 When the previous year’s investment performance ispositive but insufficient to meet the current year’s re-tirement income needs, the algorithm provides thatthe amount of the investment gain is drawn from theportfolio, and the remainder of the retirement incomeamount is taken from the reverse mortgage credit line.This algorithm and the results it produces are dis-cussed in Sacks and Sacks, supra note 8. The readermay ask about the required minimum distributions(RMDs) from the iRa when the Coordinated Strategyalgorithm provides that the retiree not draw on theiRa. The answer is that the model assumes simply thatan identical securities portfolio is established by the

retiree, outside of the iRa, to hold those RMD amounts.Thus, in effect, no disinvestment occurs when the al-gorithm provides that the retiree not draw on the iRa.

30 The authors wish to thank Dr. Tom Davison for point-ing out that the use of the reverse mortgage creditline in the Coordinated Strategy is “synergistic” withthe securities portfolio. That is, rather than being a“zero sum game,” where the increase in the securitiesportfolio would be offset by the decrease of home eq-uity, the use of the Coordinated Strategy results in along-term increase in the securities portfolio that is,in most cases, substantially greater than the decreaseof home equity resulting from the debt.

NOTES

that about $15,000 of the first $100,000of indebtedness is compound interest.

Exhibit 7 shows the estimated cu-mulative simple interest on the$100,000 of indebtedness, for each ofthe five periods described above andeach of the three assumed interestrates, plus the $15,000 of compoundinterest. In each case, the period overwhich the interest accrual is calcula-ted is the stated period minus sixyears. And for each rate, the amountof $15,000 is added to the simple in-terest, to reflect the compound interestthat had accrued from the outset upthrough the 6th year. Although theamounts shown in Exhibit 7 are sig-nificantly less than the amounts of interest on the acquisition indebted-ness from the First Example, they arenonetheless substantial.

As in the First Example, the MonteCarlo simulation is run to calculatethe amount remaining in the IRA atthe end of each of the five periodsconsidered, i.e., at the end of 10, 15,20, 25, and 30 years from the outset.The median figures, and a measure ofthe dispersion, are shown in the tablein Exhibit 8. Again, the reason for do-ing this calculation is to provide ameasure of the amount of taxable in-come against which some or all of theinterest deduction might be used, if,at the time the home is sold, the bor-rower’s, or the heir’s, other taxable in-come is not sufficient.

Again, after comparing Exhibits 7and 8, like Exhibits 4 and 5 in the FirstExample, it can be seen that there is avery high likelihood that, if the retireeor her heir does not have sufficientother income against which to use theinterest deduction, there are ampleamounts that can be drawn from theIRA to take advantage of that deduc-tion.

CONCLUSIONMany retirees will die leaving to theirbeneficiaries very substantial balances

in their IRAs or 401(k) accounts. Thesemay very well be cases in which theIRAs and 401(k) accounts have beenenhanced, or at least preserved, by us-ing the reverse mortgage for purchase(as in the First Example) or by usingstrategic draws on reverse mortgagecredit lines (as in the Second Example)to offset the deleterious effects of un-favorable sequences of investment re-turns. These strategic draws augmentretirement income and increase theamounts likely to remain in retirementaccounts.

The interest on the reverse mort-gages is, in general, not actually paidby the borrower as long as he or shelives in the home, so the interest ac-crues and compounds. Until the in-terest is actually paid, there is no de-duction. Indeed, the deduction seemsto be, and may actually be, lost.

The deduction can be “recovered”by the beneficiaries of the 401(k) ac-count or IRA, as heirs to the home it-self, if they sell the home and pay offthe reverse mortgage, instead of theestate or trust selling the home anddistributing the net proceeds. (Theconventional approach is to have theestate or trust sell the home and dis-tribute the net proceeds. But the estate

or trust is unlikely to have enoughtaxable income to benefit from the de-duction, and the deduction cannot betransferred.31)

The deduction can also be “recov-ered” by borrowers, in situations inwhich they have substantial income,or have an IRA or 401(k) account, andthey sell the home (e.g., because theycan no longer live on their own, or de-sire to move closer to adult children orinto a retirement community) and payoff the reverse mortgage. In such situ-ations, they can use the interest deduc-tion, to the extent allowed (as describedabove), to offset the income of takinga substantial draw from the 401(k) ac-count or IRA or to offset the tax costof making a Roth conversion of someor all of the 401(k) account or IRA.

In unusual circumstances, such asthe receipt of a windfall, borrowers,while continuing to live in their homes,might be able to pay off a portion ofthe reverse mortgage debt, and use thededuction to offset the income of tak-ing a substantial draw from the 401(k)account or IRA or to offset the tax costof making a Roth conversion of a por-tion of the 401(k) account or IRA. l

r 169l J o u R n a L o f T a x a T i o na p R i L 2 0 1 6R E a L E S T a T E

Second Example: Amounts in the IRA

EXHIBIT 8

number ofYears:

10 15 20 25 30

Median am’tin iRa:

$886,000 $1,017,000 $1,163,000 $1,312,000 $1,541,000

StandardDeviation:

$350,000 $558,000 $862,000 $1,375,000 $2,029,000

This table shows the median values of the amounts in the iRa, in the SecondExample, at the end of the stated number of years, when the Coordinated Strategy ofdrawing on the reverse mortgage credit line is used to augment draws on the iRa.also, shown are the “standard deviations” of those values. Moreover, the simulationshows that the probability of there being at least $500,000 in the iRa at the end ofany of the five periods is approximately 90%.

31 However, see note 14.

NOTES