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One of the big decisions retirees face, and it’s a discussion that highlights the need for advisors, is what to do with their current house.
Some interesting phenomenon notwithstanding, chances are more clients that retirees are also empty nesters, meaning it’s the couple or one person residing in the house. In a perfect situation, the house is paid off, or close to being so, and the client has substantial equity in the property. Hence, a client’s primary residence can be a valuable tool in retirement.
In ideal or close to ideal situations, clients have choices regarding how to leverage primary houses in retirement. The three prominent options are staying put, downsizing to another location or getting a reverse mortgage. Reverse mortgages enter the equation for retirees that don’t want to move but want cash flow and because many traditional lenders are reluctant to extend home equity lines of credit (HELOCs) when the borrower doesn’t have a traditional income.
For a lot retired clients, staying in the current residence isn’t attractive. It might be too big. They might still owe money on it. And on and on. Point is advisors can and should help clients decide between downsizing and reverse mortgages.
Tax Implications
For advisors in areas with high residential real estate prices, think California, Florida and the Northeast, many clients may be sitting on substantial gains on their houses. That’s great, but selling those residences can create significant tax implications.
“For example, someone in California has a $400,000 home in San Francisco. It’s worth $1.5 million. And if they sell it, the capital gains are going to be pretty extensive,” said Don Graves, president and founder of the Housing Wealth Institute and an instructor of retirement income at The American College of Financial Services in an interview with Morningstar. “And so, one of the ways to say, well, you don’t have to sell it, you could do a reverse mortgage and stay to manage your capital gains. That’s probably the exception. But for a lot of folks, the home is not the right size anymore.”
Even with the tax implications, clients fortunate enough to be sitting on substantial, unrealized primary residence profits might want to take those profits because when capital gains are paid, they can still move into a smaller home, potentially paying cash, and perhaps set aside remaining profit for needed retirement income, traveling and long-term care.
Reverse mortgages, also known as home equity conversion mortgages, carry their own costs advisors should articulate to clients. The three primary costs associated with these transactions are 2% of the appraised value of the home going to HUD, 2% of the first $200,000 going to the lender and the standard retail cost. Said another way, home equity conversion mortgages aren’t free lunches and clients will NOT be receiving the full amount of money they’re borrowing.
More Reverse Mortgage Considerations
Reverse mortgages carry some sticker shock, but there are instances in which this avenue is applicable and beneficial to some clients.
“If strategic use of the reverse mortgage allows me to leave a $300,000 larger bequest at the end of retirement net of costs, well, was it really costly to do that? No, it’s like a savings of $300,000. So, that’s really how I try to frame fees or costs. It’s not so much just in isolation” Wade Pfau, professor of retirement income in the Financial and Retirement Planning Program at The American College of Financial Services and co-director of The American College Center for Retirement Income and Retirement Income Certified Professional program director at The American College, told Morningstar. “Yes, that number looks big, but in the totality of retirement and what you’re able to do and how you’re able to build a more efficient retirement income plan, if you’re getting more out of those assets, the cost is really irrelevant to that. It’s what’s the net value at the end of retirement, and that can be a great net benefit that well exceeds these costs to set up the reverse mortgage.”
The big issue that advisors need to articulate to clients considering reverse mortgages is that if the loan outlives the client, their heirs must repay it. And if the heirs don’t have cash on hand to do that, they have a mere 30 days in which to buy or sell the house or turn it over to the lender.