If you're thinking about taking out a reverse mortgage, you need to know whether and how it will affect your income tax situation. In this article, we'll explain whether reverse mortgage proceeds are taxable, whether the interest on a reverse mortgage is tax deductible and more. (Learn the basics about this financial product in The Reverse Mortgage: A Retirement Tool and Steps To Retiring With A Reverse Mortgage.)

The money you receive when you take out a reverse mortgage is not taxable – that's the official word from the Internal Revenue Service, which classifies the proceeds as a loan advance, not income. A reverse mortgage is, indeed, a loan, though many people don't realize this. If you've ever gotten a loan to buy a car, you know that you didn't pay taxes when the car dealership advanced you that money. You repaid it in monthly installments over five years, probably using income you earned from your job for which you'd already paid income tax.

Here's another way of looking at why it doesn't make sense for reverse mortgage proceeds to be taxable. With a reverse mortgage, the lender is essentially returning your home equity to you. How did you accumulate that equity? By making your monthly mortgage payments. And, as with the auto-loan example, you made those monthly mortgage payments out of your income – income you'd already paid taxes on.

A reverse mortgage essentially gives you money that's already yours by converting equity into cash. You don't send the IRS a check when you make a withdrawal from your savings account, and you also don't owe the IRS anything when you unlock the equity you've accumulated in your home through a reverse mortgage (or through a home equity loan, for that matter – which you might consider as an alternative to a reverse mortgage).

Because the lender is giving you money for a house that you still own, you're basically getting a loan, and when you take out a loan, you usually have to pay interest. Unfortunately, reverse mortgages don't have promotions like car dealerships or furniture stores where you can get 0% financing.

The interest rate on a reverse mortgage is either fixed, if you get the proceeds as a lump sum, or variable, if you get the proceeds as a stream of monthly payments or through a line of credit. Either way, the interest isn't due until the loan is due, which can happen in one of several ways:

– You die, and you're the only borrower on the loan.

– Both you and your co-borrower (who is usually your spouse) die.

– You (and your co-borrower) permanently move out. If the house has not been your primary residence for the last 12 months, you're considered to have permanently moved out, even if you still own the home.

– You sell the home.

– You stop paying property taxes or homeowners insurance.

– You fail to maintain your home in a good state of repair.

(See Reverse Mortgage Pitfalls and The Dangers Of A Reverse Mortgage.)

How does the interest get paid when the loan is due? It gets paid the same way the principal gets paid: through selling the home, through refinancing the home or from personal assets. These are the three ways a reverse mortgage can be repaid in full. After it's paid off, either you (if you're still alive) or your heirs (if you're deceased) may be able to take a tax deduction for the interest paid on the reverse mortgage.

With a forward mortgage, the kind you have when you're paying off your house, you make monthly payments of principal and interest, and you can deduct the interest on your tax return each year. With a reverse mortgage, you don''t actually pay any interest until the loan is due, so a mortgage-interest tax deduction only exists in that one tax year. There is an exception, however: In rare circumstances, borrowers will make payments on their reverse-mortgage loans while they're still living in the home, and in this case, you can deduct the interest in the year you pay it.

As you might know, mortgage interest is only tax deductible if you itemize your deductions, and it only makes sense to itemize your deductions if they exceed the standard deduction. Because all of a reverse mortgage's accrued interest is paid in the same year, there's a decent chance it will exceed the standard deduction. (Learn more in Calculating The Mortgage Interest Tax Deduction and Tax Deductions On Mortgage Interest.)

The IRS may limit your deduction, however, because there's another key difference between deducting mortgage interest on a forward mortgage vs. a reverse mortgage. The IRS considers forward-mortgage interest to be acquisition debt, while it may consider reverse-mortgage interest to be equity debt. It depends on how you use the loan proceeds, and this is where things get tricky and a tax professional's advice can really help. Money used for renovations or repairs may be classified as acquisition debt, and you can deduct interest on as much as $1 million in acquisition debt. You can only deduct interest on $100,000 of equity debt, money used for non-residence-related purposes, such as paying your medical bills.

In addition, the terms of a reverse mortgage require that you continue to pay property taxes for as long as you live in your home. Property taxes (which the IRS calls real-estate taxes) are deductible in the year you pay them. However, this tax deduction will only benefit you if you itemize, and without high amounts of mortgage interest – or medical and dental bills that exceed a certain percent of your adjusted gross income (either 7.5% or 10%, depending on your age and the tax year) – you will probably be better off taking the standard deduction. That means you won't benefit from the property-tax deduction.

The proceeds you receive from a reverse mortgage – whether you get them as a lump sum, in monthly installments or through a line of credit – are not taxable. They're considered a loan advance, not income. The interest you pay on a reverse mortgage may be tax deductible in the year you or your heirs pay it, depending on the details of your situation.