Seniors who need extra cash or income usually think of cashing in RRSPs or RRIFs or even selling their homes.
But, depending on the circumstances, the best answer for some may be the lump sum one can get from a reverse mortgage, especially since the mortgage interest would be tax-deductible if the lump sum is invested.
A reverse mortgage is available to seniors aged 62 and over who own their homes.
Anyone taking out a reverse mortgage essentially gets a lump-sum of cash, typically around 30 per cent of the value of the home, in exchange for allowing the lending institution the right to put a first mortgage on the home.
This type of mortgage has no monthly payments. Instead, the accumulating interest is added to the principal amount each month.
Even if the accumulated interest and principal rise to a level that exceeds the value of the home, the seniors get to stay in the house for as long as they like, as long as they continue to pay the taxes, insurance and utilities.
When they die or decide to leave the home, the mortgage comes due. At that point, the house is usually sold and the proceeds used to pay off the mortgage (including the accumulated interest), with anything remaining going to the original owners.
If they have been in the house a long time and the accumulated interest and principal of the mortgage is higher than the value of the house, the owners don’t need to pay anything extra. Rather, the lender takes the hit. (This seldom happens as the lender’s underwriting of reverse mortgages takes into account the borrower’s ages and life expectancy and the trends in the real estate prices.)
One advantage of a reverse mortgage is that it allows seniors to leave in place their RRSPs or RRIFs.
Another is that the reverse-mortgage lump sum is tax free, so that there is no drain from income tax that would be otherwise payable on RRSP or RRIF withdrawals.
If the lump sum from a reverse mortgage is properly invested, the mortgage interest that accumulates each year is tax deductible.
For example, on a $200,000 house, the lump sum payment from taking out a reverse mortgage would be around $60,000.
If the $60,000 is invested in business income trusts with cash distributions of around 10 per cent annually, the extra annual income (assuming the distributions are fully taxable) would be $6,000.
At the same time, however, because the mortgage proceeds are used to earn investment income, the interest on the mortgage is tax deductible. With a current interest rate of around 7.75 per cent on reverse mortgages, the annual interest charge would be about $4,650. (While this amount would not be actually “paid” by the homeowners until the mortgage comes due when the house is sold, it is still available as a deduction against investment income in the year it is incurred.)
This means that the total taxable income would be $1,350 ($6,000 minus $4,650) even though the homeowners have use of the full $6,000 of extra income generated by the invested lump sum from the reverse mortgage.
An added benefit is that the annual income from these investments would not disappear if the house is sold since the investments would not have to be sold to pay off the mortgage. Rather, the mortgage would be paid from the sale proceeds.
As initially noted, it depends on the circumstances as to whether the reverse-mortgage route to boosting income is the right one for a senior or senior couple. Current income, available assets and various other factors would have to be taken into account.
Seniors whose priority is to preserve their family home as an inheritance for their children may want to choose another way of boosting annual income.
Also, it may not make sense to take out a reverse mortgage for some seniors who may have the alternative of selling their home and moving in with children, or who may need to move into a nursing home. In such circumstances, the outright sale of the home and investment of proceeds could be the right approach.
But for others, especially those wanting the familiarity and comfort of remaining in their homes as long as possible, a reverse mortgage may be the answer, especially since the interest is tax deductible and it allows the continued growth and tax deferral of any RRSP or RRIF assets.
The 10-per-cent return on investment assumed in the above example is likely a best-case scenario. But it is also a realistic one, as there are many good business income trusts currently paying cash distributions in excess of 10 per cent. An even higher cash pay-out is available with oil and gas royalty trusts but with possibly higher risk.
If the intention is to invest the lump sum in bonds or GICs paying 5 per cent or less, the advantages would still be there but would not be as great.
The benefit could also be diminished if the extra investment income leads to a claw-back of monthly Old Age Security payments. For seniors with annual incomes already in excess of $50,000, it would be a good thing to consult a tax accountant before making a move.
Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.
The URL for this page is http://www.smartinvesting.ca/articles/20040624010100.html .
©2004 Wayne Cheveldayoff