(Huge) tax perk for house sellers

As we discuss in detail in Chapter 16, house sellers can shield a big portion of their house sales profits from taxation. Single taxpayers can avoid capital gains taxation on up to $250,000 and couples filing jointly up to $500,000 of profit.

As long as you lived in the house as your primary residence for at least two of the previous five years, this tax exclusion is available to you without age restriction, and you can take the exclusion as many times as you want (but no more than once every two years).

This law (passed in 1997) is more expansive than the old exclusion rules, which required you to be at least 55 years old. (The old rules allowed you to take an exclusion only once per lifetime, and even then allowed an exclusion of up to only $125,000 in house sales profit from capital gains taxation.)

Presuming that you’re willing to sell your primary residence, the new house sales tax law makes it easier to convert your home equity directly into liquid investments you can live off during retirement. Of course, such a strategy requires you to either trade down or become a renter. Trading to an equal cost or more expensive home won’t free up more of your money.

Renting versus trading down

Usually, trading down is financially savvier than becoming a renter. If you’re able to pay for your new home in cash, your housing costs during retirement could be greatly reduced.

The price range you should consider depends on a couple of factors:

• How much other money do you have for retirement? If you’re really pinched for money to live on during retirement, you may be willing to buy a considerably less expensive home to free up more money for living expenses. Until you run some retirement projections to see where you stand, however, you won’t know how much or how little you need to carve off your home’s equity. And, as we cover in the next section, you can use a reverse mortgage to tap into your property’s equity while you still live there.
• What do you want to buy? If your retirement dream is to live on New York’s Upper West Side or near the water in Hawaii, you may not be able to trade down much. However, if living in Manhattan is more your idea of a retirement nightmare than a dream, and you want to scale down and move out to the countryside, you can probably spend much less on your next home.

Some people sell their houses and simply rent in retirement. By selling, you free up all the money invested in your house and make it available to live on or do with as you desire. And when you rent, you have more flexibility to move in the future.

If you’re considering the sale of your house and becoming a renter in retirement, be aware of these potential drawbacks:

• Exposure to rental inflation: As a renter, unless you live in a unit protected by local rental-control ordinances, your monthly rental payment is fully exposed to inflation. Today, $1,000 per month in rent may not sound like a mountain of cash, but consider that, with annual increases of only 4 percent, in 20 years, your rent will mushroom to nearly $2,200 per month. With 6 percent annual rental increases — which can happen if the United States returns to a 1970s-style period of higher inflation — that $1,000 monthly rent balloons to more than $3,200. Ouch!
• Obeying your landlord: As a homeowner, you get to call the shots. You can change the interior and exterior of your home as you please. As a renter, you’re largely at the mercy and whims of your landlord. If you’re used to owning your own home and not having to answer to a landlord, adjusting to the realities of tenant life can be difficult. So, if you do sell and return to the ranks of renters, spend as much time inspecting and interviewing your prospective landlord as you do examining the rental unit. Remember that your landlord can sell the building, possibly forcing you to move again — with added expenses.

Reverse mortgage basics

So what exactly is a reverse mortgage, and how does it work? Well, as the name suggests, a reverse mortgage reverses the traditional mortgage process. Think back to when you bought your first home. Unless you had generous and affluent relatives, you probably had to scrape together the money for the down payment and seeming never-ending closing costs. And then you were likely saddled with what seemed like a mountain of mortgage debt.

Every month, thereafter, you dutifully mailed to the mortgage lender a check for the monthly mortgage payment. In the early years of your mortgage, a major portion of those monthly mortgage payments went to pay interest on your outstanding loan balance, but a small amount of each of payment went toward lowering the principal, or in other words, reducing the loan balance. (As the years roll by, the loan balance should pay down at a faster and faster rate until, eventually, your mortgage is paid off.)

A reverse mortgage reverses that process. When you take out a reverse mortgage, the mortgage lender typically sends you a monthly check. Imagine that! You can spend the check any way your heart desires. And, because the check represents a loan, the payment to you isn’t taxable.

As the reverse mortgage lender gives you more payments, you accumulate an outstanding loan balance. You typically don’t have to pay back your reverse mortgage loan until the home is sold (and then the loan and the accrued interest is paid back from the sale proceeds) or, with most reverse mortgage programs, when you move out of the property.

Reverse mortgage payment options

The whole point of taking out a reverse mortgage on your home is to receive money that is drawn from the equity you have in your home. How much can you tap? That amount depends mostly on how much your home is worth, how old you are, and the interest and other fees that a given lender charges. The more your home is worth, the older you are, and the lower the interest rate and other fees a lender charges, the more you should realize from a reverse mortgage.

You can decide how you want to receive your reverse mortgage money:

• Monthly: Most people need monthly income to live on. Thus, a commonly selected reverse mortgage payment option is monthly. However, not all monthly payment options are created equal. Some reverse mortgage programs commit to a particular monthly payment for a preset number of years, and other programs make payments as long as you continue living in your home or for life. Not surprisingly, if you select a reverse mortgage program that pays you for the rest of your life, you’re going to receive less monthly, probably a good deal less, than from a program that pays you for a fixed number of years.
• Line of credit: Rather than receiving a monthly check, you can simply create a line of credit from which you draw money by writing a check, whenever you need income. Because interest doesn’t start accumulating on a loan until you actually borrow money, the advantage of a credit line is that you pay for only what you need and use. If you have fluctuating and irregular needs for additional money, a line of credit may be for you. Because you have to take the initiative to draw on a line of credit, some thrifty seniors have a hard time tapping and spending the money. The size of the line of credit is either set at the time you close on your reverse mortgage loan or may increase over time.
• Lump sum: The least beneficial type of reverse mortgage is the lump sum option. When you close on this type of reverse mortgage, you receive a check for the entire amount that you were approved to borrow. Lump sum payouts usually only make sense if you have an immediate need for a substantial amount of cash for some purpose, such as wanting to gift money to family or to make a major purchase.
• Mix and match: Perhaps you need a large chunk of money soon for some purchases you’ve been putting off, but you also want the security of a regular monthly income. You can usually put together combinations of the preceding three programs. Some reverse mortgage lenders even allow you to alter the payment structure as time goes on. Not all reverse mortgage lenders offer all the combinations, so shop around even more if you’re interested in mixing and matching your payment options.

The costs of reverse mortgages

Reverse mortgage lenders, of course, aren’t charities; they make money on reverse mortgages by charging an interest rate on the amount borrowed and by collecting other fees. Although many of the costs of a reverse mortgage are similar to those charged on a traditional mortgage loan, some are unique. On a reverse mortgage, you typically see these types of fees:

• Interest: As with a traditional mortgage, the interest rate on a reverse mortgage can either be fixed or adjustable. Fixed-rate loans offer peace of mind because you know upfront what your loan’s interest rate will be. However, you typically end up paying more interest over the life of the loan for the security of a stable interest rate.

  With adjustable-rate reverse mortgages, the overall level of market interest rates determines your loan’s future interest rate. If you get an adjustable-rate mortgage and rates significantly increase, your outstanding loan balance increases faster, thus leaving less equity for the day when your home is finally sold. Odds are better, though, that an adjustable-rate loan will save you on interest costs over the long run because interest rates rarely skyrocket and remain elevated. Because you’re taking on additional risks with an adjustable loan, you’ll probably owe less total interest on your reverse mortgage with more equity remaining for you and your heirs after your house is sold.

  Fixed-rate reverse mortgages make the most sense for seniors who anticipate using their loans over a number of years — preferably seven or more. Fixed-rate loans also help you sleep better at night if you’re the type who frets over fluctuating interest rates.

• Upfront fees: Most reverse mortgage lenders charge you fees for processing your application, fees for pulling a copy of your credit report, and other fees for originating your loan.
• Closing costs: Your reverse mortgage lender will want to appraise your home to determine its worth. This appraisal helps determine how much you can borrow on your home. The more your home is worth, the more money a reverse mortgage lender lets you tap from your home’s equity. Other common closing costs include title insurance, local recording fees, and inspections.

• Insurance costs: When a reverse mortgage lender commits to giving you a reverse mortgage, the institution is taking a risk. If you live much longer than the lender expects, and your home’s future value falls far short of the expected worth, the reverse mortgage lender can lose money if the amount of your outstanding loan balance exceeds the value of your home. To reduce the risk, mortgage lenders buy insurance. And guess what? You get to pay for the insurance, either as a yearly fee (sometimes called a risk pooling fee) or as a percentage of your home’s value when you take out your reverse mortgage.

  A reverse mortgage insurance premium of up to 2.5 percent of the home’s value is payable at closing. This premium is just 0.5 percent if you take no more than 60 percent of the approved funds. In addition to the upfront insurance charge paid at closing, there is also an annual mortgage insurance premium of 1.25 percent of your reverse mortgage balance. This ongoing premium accumulates and is owed and paid once your loan ends and is paid back.

• A portion of your home’s value or future appreciation: Some reverse mortgages include an additional cost. On some loans, this cost is based on a portion of the appreciation in your home’s value from when your reverse mortgage began. On other loans, this added cost is a portion of the value of your home when your reverse mortgage is ultimately paid off from the sale of your home.

Understanding and shopping for reverse mortgages takes time and patience. Don’t rush the process. A number of nonprofit counseling agencies, supported through government funding, stand ready to assist you with sorting through the reverse mortgage options in your area. At the state level, check with the Department of Aging; at the local level, check with the Area Agency on Aging (call the Eldercare Locator Service at 800-677-1116 or visit its website at www.eldercare.gov/ for the agency nearest you). We also encourage you to pick up a copy of the latest edition of Mortgage Management For Dummies (which Eric co-wrote with Robert S. Griswold) for its wealth of useful material about all types of mortgages, including reverse mortgages.