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Feb 1994

House rich but cash poor. (Personal Financial Planning)

by Holt, Michael A.

    Abstract- Many older Americans are finding that owning a house free of mortgage debt is not enough preparation for retirement since home equity cannot be used to pay for the cost of every day living. For these house-rich but cash-poor individuals, the only options available seem to be to ask their children for financial assistance or to sell their house and move to a more affordable one. Because both choices are unpleasant for many senior citizens, both the public and private sectors have intensified their efforts to find more acceptable solutions. Two of the most common approaches devised to unlock the elderly's home equity without them having to give up their homes are sale-leaseback arrangements and reverse mortgages. Under a sale-leaseback agreement, elderly people can sell their house to an individual who will lease it back to them. In reverse mortgage transactions, on the other hand, the elderly qualify for a mortgage loan based on their home equity.

The first option--seeking financial assistance from children is not a viable alternative for many families. Some parents may learn their children's resources are not sufficient to fully provide for their needs. For example, children of the "baby boom" generation may be overwhelmed by the triple burden of simultaneously providing for their parents, funding their children's education, and maintaining their lifestyle while planning for their own retirements.

In addition, many parents feel asking children for assistance is not palatable or practical. Consequently, many house-rich, cash-poor retirees have been forced to sell and move elsewhere.

Some may be encouraged by the tax relief available in the form of a one- time exclusion of gain up to $125,000 on the sale of their principal residence, in combination with the capital gain rollover treatment used to defer any remaining gain (i.e. if the purchase of another, less- expensive residence is feasible). Under a variety of circumstances, however, the first tax relief provision may no longer be available, or the two provisions--viewed either separately or combined--may not be sufficient to remove the prospect of an immediate diminution of the remaining estate through the payment of income taxes. Regardless of the tax implications, some homeowners may also be hesitant to sell their homes because current economic conditions have created what they hope will be only a temporary decline in the market value of their homes. Finally, some retirees may simply not want to move from their homes due to the trauma associated with relocating to new and unfamiliar surroundings and the possibility of leaving family, friends, and fond memories behind.

In response, the public and private sectors have increased their efforts over the past decade to develop ways for older Americans to unlock their home equity while remaining in their homes. The two most common "home- equity conversion" plans are sale-leaseback arrangements and reverse mortgages.

Sale-Leaseback Arrangements

Elderly individuals who need additional income but do not want to move from their homes might consider a sale-leaseback arrangement. In a sale- leaseback, an elderly individual or couple can sell their home to an interested party, who would then lease the home to the couple. The purchaser obtains third-party financing or secures financing from the seller. Under ideal circumstances (from the seller's viewpoint), a seller-financed version of this transaction would enable elderly homeowners to achieve three favorable results: 1) an immediate inflow of cash in the form of a down payment from the buyer; 2) a continuing positive cash flow in the form of monthly receipts of amortization proceeds (plus interest) that are greater in amount than the monthly rent to be paid to the buyer/lessor; and 3) the right to remain in their homes for life. The last condition can be achieved if the lease term substantially exceeds their life expectancy or they have the contract to indefinitely renew shorter-term leases at their option.

However, finding a buyer interested in such an arrangement may be difficult. True, there may be certain tax benefits available to the buyer, such as the ability to depreciate the property and deduct property taxes, maintenance, and other rental expenses (for which the seller is generally no longer responsible), but the passive loss rules and other restrictive provisions introduced by the TRA 86 have made these tax benefits much less appearing. Furthermore, these benefits would be available to a potential real estate investor even if he or she were not bound to the more restrictive terms of a sale-leaseback arrangement.

Assuming such a buyer can be found (very often a family member or group of members who want to help their parents remain in their home), the buyer may discover that achieving the three results discussed may still be difficult. For example, the seller may learn that the down payment received from the buyer may not even be enough to cover the capital gains tax imposed on the sale. In this case, the seller's initial liquidity would not be any greater than it was before the transaction-- and he or she would no longer own the home. Furthermore, if the down payment were large enough, it is likely that an elderly individual or couple would still wish to avoid a loss of the wealth through an immediate imposition of income taxes.

If the buyer is a family member or group of members who are named as beneficiaries in the elderly couple's will, they too would probably find their interests would be better served if they provide the couple with financial support, since the full value of their relatives' estate-- undiminished by income taxes--could then be passed to them at death. It is also likely that, under these circumstances (i.e., where the elderly couple does not possess substantial wealth), little or no estate tax would be imposed on the property if it remained in the couple's estate. Potential parties to a sale-leaseback arrangement should be cautioned that efforts to minimize the amount of gain recognized upon the sale of the home by lowering its sales price would be limited by the fact that the sales price must generally reflect market value.

Assuming the sale-leaseback transaction makes sense, the second and third objectives must be addressed. Extending the lease term for a period beyond an elderly couple's life expectancies may result in an obligation for rent payments that extends beyond the period during which they are to receive interest and sales proceeds from the buyer. If, to address this problem, the term of the loan is likewise extended, the couple may be faced instead with monthly payments from the buyer which fall below the level of their monthly obligation for rent.

One way sellers might resolve this conflict would be to use the down payment received upon the sale of their home to purchase or otherwise fund a future annuity. When considering this option, the determination of the timing and amount of such an annuity must be integrated with the analysis of the appropriate loan and lease terms, as well as with the amount of the down payment to be required. In other words, the cash flows from the loan must be sufficient to cover monthly rent payments and other ongoing cash flow requirements, and the down payment must be large enough to fund an annuity that will cover the seller's monthly expenses after the loan term has ended. Table 1 should clarify the impact of these tradeoffs.




















In assessing the need for an annuity, it is important the sellers consider certain other factors as well. First, the interest portion of the payments received from the buyer will represent taxable income to the seller. Consequently, a potential seller should express the payments to be received from the buyer in after-tax terms when comparing these payments to his or her monthly rent obligation. Furthermore, the receipt of this income could also result in increased taxes on Social Security benefits and a reduction in the amount of various "means-tested" public benefits--such as Supplemental Security Income, Medicaid, and/or food stamps--that elderly individuals may otherwise be entitled to receive. Finally, the need for the new owner to raise the rent in the future will gradually reduce, and possibly eliminate, any positive after-tax cash flow that the sellers might initially receive based on payments from the buyer alone. Rent increases may be necessary because, just as the sales price of the residence must reflect market conditions, the rate of rent must be consistent with local rental rates charged for similar properties, if the tax status of the transaction is not to be jeopardized.

Beyond all the numbers, another potential drawback is the requirement that retirees give up title to their homes. This can lead to unintended results. For example, if the buyer divorces, his or her former spouse might end up owning the house instead of the seller's child.

Reverse Mortgages

Like a home-equity loan, a reverse mortgage (RM) is a loan secured by the borrower's principal residence. However, unlike a home-equity loan, an RM permits borrowers to qualify based upon their home equity rather than on current income, since RMs require no loan repayment until a future date. Furthermore, the total amount to be repaid generally cannot exceed the borrower's equity in the home. Title to the home is retained by the borrower. If the loan is not insured, its term will generally be fixed. In such a case, the homeowners would be confronted with the risk of outliving the term of the loan and being forced to sell to avoid foreclosure and eviction. To address this risk (as well as the risk of lender default), most RMs available today are insured either by private insurers or by the Federal Housing Administration (FHA).

Under the terms of most insured RMs, no repayment is due until the borrower either dies, sells the home, or permanently moves away. To obtain this additional security, insured RM borrowers' loan costs will include an insurance premium and, in some cases, a monthly service fee. For example, FHA-insured RMs charge an "upfront" premium equal to 2% of the "maximum claim amount," an additional monthly insurance premium equal to an annualized rate of one-half percent of the outstanding loan balance, and a $25 monthly servicing fee.

FHA-insured RMs became available in 1989. They are available to homeowners aged 62 years or older. However, co-op owners are still excluded. The specific dollar amount of loan advances available through an FHA-insured RM depends on four factors: 1) the borrower's age upon beginning the program; 2) the value of the borrower's home; 3) the overall cost of the loan; and 4) the specific loan plan chosen. The FHA program, however, places a limit on the amount of home equity that can be used to determine loan payments. The limit varies by county and currently ranges between approximately $75,000 to $150,000.

Table 2 illustrates how an individual's age and home value affect the amount of "tenure" loan advances (i.e., monthly advances for as long as the borrower lives in the home) that may be available through an FHA- insured RM.

The insurance premium costs, the origination fee, and the other closing costs may vary among potential lenders and should be shopped.

Three types of loan advances are available through an RM: 1) monthly advances for a fixed term; 2) tenure advances; and 3) a line of credit enabling the borrower to decide the timing and amount of the advances. FHA-insured RMs provide all three types of loan advances and permit the borrower to switch from one payment option to another at any time. Lender-insured RMs are generally less flexible, and uninsured RMs usually provide only the first type of loan advance. A similarity among virtually all RMs is the ability to request an initial loan advance at closing.

Monthly loan advances available from lender-insured RMs are generally fixed in amount, based on prevailing interest rates at the time of closing. The interest rate itself is usually variable and subject to annual adjustment based on some index such as the ten-year U.S. Treasury securities rate. These loan advances are generally greater than those available from FHA-insured RMs. However, the insurance premium on lender-insured RMs will also usually be greater, perhaps as high as 7%. Another difference between lender-insured and FHA-insured RMs is that many lender-insured RMs permit the borrower to "reserve" a percentage of home equity. On the other hand, with FHA-insured RMs, the lien is against the entire equity of the home. The borrower may retain some equity if he or she borrows less than the full value of the home.

Advantages to RMs are that the loan advances are nontaxable and do not affect Social Security or Medicare benefits. Supplemental Security Income benefits likewise will be unaffected by RM advances, provided the advances are spent within the month they are received. This is also the case for the Medicaid program in most states.

An RM as the name implies, results in an increasing loan balance with a corresponding decrease in the owner's equity. This concept of falling equity and rising debt is illustrated in Table 3. It assumes monthly loan advances of $500 per month, a 10% average annual interest rate (compounded monthly), and an average annual increase in the value of the borrower's home equal to 4%. "Upfront" costs were assumed to be paid from the borrower's own funds. Financing these costs during the initial term of an RM can have a significant impact on the total loan cost.

If the average annual rate of appreciation in the value of the home were only 2% instead of 4% the loan balance would "catch up" with the value of the borrower's "unreserved" home equity in year 15, and thereafter the loan balance would generally be limited to any further increases in the value of such equity.














Potential RM borrowers should also be aware that the interest on an RM is not deductible until the end of the loan term when payment is made. If the estate repays the mortgage, the executor should arrange to do so in the last year or the estate when the final income tax return is filed. Any unused interest on the estate's return will be passed out to the beneficiaries as an "excess deduction."

























The Right Option

For homeowners with financially able heirs, a sale-leaseback arrangement or some form of family assistance may be preferable to an RM. But, under certain circumstances, an RM may be useful.

Before entering into either a sale-leaseback or an RM, elderly homeowners should first be very clear as to what their needs are. In addition to the income and estate tax implications discussed earlier, they should first ask themselves some very basic questions: Do they really need more money every month for regular expenses? What is their attitude toward sharing their home with a tenant? Are property taxes a major burden? Are they concerned about specific, non-recurring needs such as a home repair, automobile purchase, or future health costs? What is their attitude toward leaving some equity for their heirs? Under what circumstances would they be willing or able to move?

Answering these questions may not only help to determine which of the alternative discussed above may be preferable, but could also lead to the discovery of still other options. For example, renting a part of their home could generate the additional monthly income that they require. Various types of tax relief, including property tax deferral programs, may be available from Federal, state, and local governments. Small but inexpensive public sector deferred payment loans to make home repairs or improvements may be offered by a local government agency. Energy assistance programs provide help with heating, cooling, and weatherizing expenses. Medicaid covers the cost of certain health care expenses for persons with low incomes and limited assets.

The above is just a sample of additional alternatives from which elderly homeowners may be able to choose. An additional source of information is the American Association of Retired Persons. They offer a free 47-page consumer guide, Home-Made Money, along with a list of over 100 reverse mortgage lenders. To get both, send a postcard to: AARP, Home Equity Information Center, 601 E Street N.W., Washington D,C.

Michael A. Holt, CPA, Mahoney, Cohen & Co., PC

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