Using Housing Wealth and Qualified Retirement Benefits to Facilitate Asset Division in Silver Divorce

So, what do we have? Qualified retirement plans are the most common kind of retirement savings. Typically, they are in defined contribution plans like 401(k)s and IRAs. These are assets to be managed and provide a source of income during retirement.

For some retirees, the value of their retirement benefits is comparable to or greater than the value of their home. For most others, the value of their home equity is greater than that of their retirement benefits. The point is that these are the significant assets for most people who are seniors.

Some people have other assets like rental property or life insurance policies. But for most people who have anything, it is their home equity and retirement savings.

Accessing Housing Wealth Through Reverse Mortgages

Let’s first discuss a reverse mortgage because that is how housing wealth can be accessed in the most useful and beneficial way.

In simplest terms, a reverse mortgage, as most of you know, is just a loan. It is not a transfer of wealth to the bank. It is not anything but a loan but has this unique feature. Unlike any other loan, repayment is only required once the borrower ceases permanently to use the home as their principal residence. That is crucial to our considerations because the loan provides cash inflow when needed, but without increasing their later cash outflow. Remember, that is the crucial point in retirement. In retirement, cash must be managed with great discipline.

The reverse mortgage loan is a loan that does not increase. It is not a taxable event and does not increase your income. It can be repaid once the home is sold, when the borrower permanently leaves the home, or, for that matter, when it is refinanced by the borrower’s heirs if they choose to keep it. That happens occasionally, although it is not a widespread occurrence.

A reverse mortgage provides liquidity, that is, cash, for the following purposes, and it can be highly beneficial. One situation is if one ex-spouse wants to keep the home. If one ex-spouse keeps the home, the cash from the reverse mortgage enables that ex-spouse to buy out the interest of the other ex-spouse. If the couple sells the home and the net proceeds are divided, then the cash from reverse mortgages can enable each to buy a new house.

These are called HECM for Purchase reverse mortgages. HECM is the acronym for Home Equity Conversion Mortgage, which is the most prevalent kind of reverse mortgage. Using a reverse mortgage as a purchasing tool for people is becoming increasingly popular as retirees, and their advisors become aware of it.

How can you divide retirement savings if it leaves each ex-spouse with insufficient money for a comfortable retirement? Reverse mortgage cash in the form of a line of credit can serve as an external source of money that offsets the inherent volatility of investments in the portfolio. Think about it. A 401(k) account or a rollover IRA is typically invested in securities. One must accept the inevitable pair that if one expects long-term growth, one must expect short-term volatility. It goes up and down on the way up.

If one draws from a portfolio when it is down, that increases the likelihood that the portfolio will run out of money. Again, that is the thing to watch out for. You want to avoid running out of money in later years. More generally, reverse mortgage cash can enhance retirement for ex-spouses in many ways, including as I have just described.

Professionals who advise people in the context of divorce must understand this flexible financial tool and how it works so they can feel comfortable advising their clients about using it. Unfortunately, people unfamiliar with reverse mortgages might have a negative, almost instinctive reaction. However, it is a very useful tool, and it is important to dispel some of the widely held misunderstandings about reverse mortgages.

First Example: Buyout Scenario with No Existing Mortgage

This is the simplest example: Joe and Laura are divorcing. They own a home valued at $800,000, free and clear. Let’s say they also own a classic car worth $50,000.

In this case, Laura wants to keep the home. As a result, she’ll keep the home, and Joe will leave and get his own house. Dividing the assets equally means $850,000 divided by 2, so each party is entitled to $425,000.

The first step is for Laura to obtain a reverse mortgage for $375,000 and purchase Joe’s interest in the home. She will also give him the classic car worth $50,000. With the $375,000, this comes up to the $425,000 he is entitled to.

In this step, Laura keeps the home, and all mortgage repayments are deferred until she permanently vacates. That is the whole point of a reverse mortgage: no cash outflow. She also keeps the current property tax rate, as happens in California.

What about Joe? Joe gets a loan, also. He uses the $375,000 that he got in cash from Laura, and he gets a HECM for purchase, a reverse mortgage as a purchase loan to purchase a new home worth $700,000. It is smaller than the $800,000 home that he and Laura shared. That is okay because he is now by himself. The $800,000 house might have been where they raised kids. Typically, the kids are grown up and gone in a silver divorce.

Generally, reverse mortgages are between 40% and 60% of the house’s value up to the current home value limit of $1,149,825, depending on the borrower’s age and loan rate.

The most important thing to remember is that both parties remain homeowners, not renters. Think about that. The age at which civil divorce occurs and years after that, the last thing one wants to be is a renter subject to the whims of a landlord. It is hard enough to move at any age, but at a later age, when one has gotten used to where one lives or neighborhood or community, one does not want to be at risk of having to move or having an unexpected incursion made into cash outflow.

As a result of this scenario, neither party incurs any monthly mortgage payment obligations, and no rent is ever due. Neither party had to draw upon income-producing assets, such as their securities portfolio. Again, no capital gain tax or sales fees were incurred. These are all very favorable results for both parties.

Now, there are the tax considerations. The purchase and sale between spouses or ex-spouses’ of a marital home incident to divorce do not give rise to the recognition of capital gain. This is good news, set out specifically in Internal Revenue Code section 1041(a). Now, here comes the bad news. There is a carryover basis. That is the ex-spouse who retains the home; in this case, Laura has generally paid the current value of the departing ex-spouse’s portion. Typically, we know that over the years, the values of homes have increased substantially despite some volatility.

The remaining spouse retains the departing ex-spouse’s tax basis, meaning what they have paid. So upon the later sale of the home by, in this case, Laura, who retained the home, tax is calculated on the original cost basis of the home. In other words, if they bought this house for $200,000, then Joe sold his half for $400,000, and Laura is deemed only to have paid $200,000 for the entire house. That is $100,000 for her and $100,000 for Joe. Therefore, when she sells it, that gain will be recognized. That is the other part of Section 1041.

Second Example: Asset Division Scenario

This is a different couple. Neither party wants to retain the house, so they sell it. Their house is worth $1,650,000, much more expensive than the one that Joe and Laura had in the example above. They had an existing mortgage when they sold it for $600,000. Because they sold it on the market, presumably using a real estate agent, there is a sales fee, and we estimate $95,000. That is a reasonable number for a house that size.

There is a capital gain tax to pay because it is sold to an unrelated party. There is $800,000 left over, and they divide the cash 50/50, or $400,000 for each.

Each party uses their share of the net cash as part or all of the down payment on a new home. Each party then obtains a HECM for the remainder of the home purchase valued in the $700,000 range.

Using the HECM proceeds of $300,000 and the $400,000 cash, each of a couple ends up owning a house free and clear in the sense that no debt service must be paid as long as they live in the house. Again, favorable results for both parties. As I said before, they become homeowners, not renters, which is particularly important as people age. Neither party incurs any monthly mortgage payment obligations. Neither party has had to draw upon any income-producing assets. Both parties participate equally in the sales fees and capital-gaining taxes.

Again, let’s look at the tax considerations. In this one, a capital gain is recognized. However, an exclusion is set out in Internal Revenue Code Section 121, and the regulations say the amount of gain that can be excluded is $250,000 for each individual or $500,000 for a couple filing a joint return. Now, it is important to note, because now we get into some of the weedy stuff about tax law, a joint return cannot be filed for the year when the divorce becomes final, even if they still need to divide up all the assets.

In California, we have what is called bifurcated divorce, where people can become single from the standpoint of their marital status and still argue, fight, pay lawyers, and have a terrible time dividing up the assets or the financial part. Marital status can be resolved relatively quickly. When there are assets to be divided, that might take much longer, but it does not delay the marital status change.

Here is one of the considerations for this exclusion. If the couple has been living apart for some time before the divorce becomes final, the home sold may be treated as the principal residence of only the party living there. However, the rule is complicated because it says that one is entitled to that $250,000 exclusion if one has lived there two out of the last five years. But you must measure this in months. What does it mean to be living there? Can visiting there to pick up your stuff or does cleaning up the place count? I am currently involved in a case where the people are fighting precisely that. It is a $2 million house in Berkeley Hills, and the argument is how much time he spends there. During which months can he get his two years of residence during the last five years? I am looking forward to seeing how that case comes out.

Third Example: Buyout Scenario Involving a 401(k) Account

Jack and Jill are divorcing. They own a home worth $800,000, free and clear. Jill wants to keep the house, and Jack wants to travel. Jack may later rent a house. Jack also has $1.2 million in a 401(k) account.

Under the agreement, Jill keeps the house and $200,000 in the 401(k) account, which she can roll over to an IRA. Jack gets the rest of the 401(k), valued at $1 million, and rolls it into an IRA.

Using the four percent retirement income rule, Jack will be able to draw $40,000 per year from the $1 million IRA. Added to a typical Social Security amount of $25,000, he’ll have an annual income of $65,000. That is reasonable, acceptable, and manageable. It is not colossal.

Using the same rule, Jill can also draw four percent from the $200,000 for $8,000 a year. Even with Social Security, assuming that she gets some of Jack’s Social Security upon divorce, though it is not very much. The question is, is there a better way?

Here are the tax considerations. Jack’s and Jill’s income will come from IRAs and Social Security. The IRAs will be taxed as ordinary income. Jill’s Social Security piece will be taxed at a low rate. About 50% of it will be taxed at whatever her bracket is. As a result, her income, which is already too little to maintain the house and provide living expenses, is further reduced by some income tax. Obviously, with her small income, her tax rates will be relatively low. Indeed, the Social Security tax may be zero because the other income is so low. Determining how much Social Security income is taxed is a complicated procedure. It is always less than ordinary income, but how much less depends on the other income.

We’ve got a second way to examine this situation. Again, the home is valued at $800,000. Jack wants to travel and later rent a home. Jill keeps the house and obtains a reverse mortgage for $300,000.

To accomplish equal division, Jack will get $300,000 of cash under the agreement and QDRO as before and an IRA valued at $ 700,000. This leaves $500,000 in Jill’s 401k account or IRA. In Jack’s retirement, he’ll be able to draw $28,000. That is four percent of the IRA annually, again, adjusted for inflation in subsequent years and another $12,000 from having invested the $300,000 he had. He is getting a total income of $40,000. Again, added to his Social Security of $25,000, he’ll have the same income he had before. Different tax rates apply to different sources of investment capital.

Jill now has a $500,000 IRA that gives her $20,000 a year. This is much better than the $8,000 that she would have had from the $200,000 401(k) or IRA. However, the amount is still taxable as ordinary income.

The favorable result is that Jack will have less tax to pay than under the first way because some of it is capital gain. The lower income may result in the Social Security piece being taxed less. Jill gets much more cash flow and more money invested with greater long-term potential wealth but also, of course, greater risk.

Another way a reverse mortgage could benefit both members of the divorcing couple, for both the asset division and the provision of returned income, is when the home value is greater than the securities portfolio value. This is shown in an article that Pete Neuwirth and I wrote, along with my brother Steve Sacks, the brilliant computer programmer in the family. We published “Integrating Home Equity and Retirement Savings through the ‘Rule of 30’” in the October edition of the 2017 Journal of Retirement of Financial Planning.

This research shows that when you have a high ratio of home value to portfolio value, you get so much buffer and more help that you can withstand a lot more draw from the portfolio. We showed that even with an initial draw of eight percent of the portfolio, when there is a house that is close to twice as much value as the portfolio, you can get an eight percent initial draw rate and keep drawing that for 30 years with a 90% probability that the portfolio will last 30 years, inflation-adjusted, so it is constant purchasing.

Reverse Mortgage Overview

This is the third stop on our travels. Now that we’ve given you some examples of how reverse mortgages can be used, both as a buffer asset to help the draws from the securities portfolio and as a way of making it much easier to divide up a home, let’s learn a little bit more about reverse mortgages.

Who’s eligible? It must be the primary residence of the borrower or borrower. Typically, the borrowers must be older than age 62. Some so-called proprietary reverse mortgages, not HECMs, have an earlier eligibility age. The loan amount is lower if there is a younger than age 62, so-called eligible non-borrowing spouse. Interestingly, that protects a younger spouse, such as if the couple’s wife is 62 or 63 and the husband is 56 or 57, which is an actual case that I am working on now.

Only the older spouse can be the borrower if a couple gets the reverse mortgage. The eligible non-borrowing spouse is protected if the older spouse dies while the couple is living in the house. This is not a divorce situation. I do not know how that would be carried out if divorce were to occur.

The residences themselves can be single-family homes or condos approved by HUD. They can be one- to four-unit buildings where the borrower occupies one unit and rents out the others. In some states, co-ops are also allowed. The amount typically available is a function of the borrower’s age and the value of the home. That goes up to a maximum value of $1,149,825. They’re raising this number often now, once every year. It used to be every few years.

Obviously, the older the borrower, the higher the amount available because the amounts are based on actuarial calculations. Typical numbers are that borrowers in their 60s can get 40 to 50% of the home value, and borrowers in their 70s can get approximately 50 to 60% of the home’s value.

Here are some features and limitations. The most important feature is that a reverse mortgage is a loan with no monthly repayments. If no repayments are due, they’re only due when the borrower permanently leaves the home. As I often say, that can be either vertically or horizontally.

It is for primary residences. If it is one to four units, then the borrower must live in one of the four units or one of the three or two if it is multi-units. It cannot be used as a hotel or for Airbnb. They have minimal income and credit requirements to ensure people can pay their property taxes and insurance. You must keep these things insured.

The borrower retains title and can sell or refinance it at any time. That is crucial to understand. It is not anything but a loan. The heirs inherit the total value of the home subject to the mortgage debt. That is standard and would be the same if there were a conventional forward mortgage. It is the same as a conventional mortgage or HELOC debt, except that no repayment is required during residency.

HECMs are insured and regulated by HUD. It is also nonrecourse. One of the calculations I am doing right now in working is using a reverse mortgage for Roth conversion. A large chunk of a reverse mortgage loan is taken early in the game and runs up several years. It is a variable rate and property values can go down as well as up. If the debt exceeds the home’s value when the borrower leaves, there is no additional recourse against the borrower if they are still alive or if the borrower dies. Only the property is liable for the debt.

The money can be drawn in any of four ways or any combination. It can be drawn as a lump sum, a line of credit, an annuity, or a tenure payment, which is a series of payments for a predetermined number of years. Tenure payments are very flexible and can be changed once one starts. If a small lump sum is taken, a line of credit can be obtained for the rest.

This is the interest rate. It is generally variable, but a fixed interest rate can apply to a lump sum that is drawn. There are fees, but they’re not out of the borrower’s pocket. The critical consideration is that the significant fee, the initial mortgage insurance premium (IMIP), is a one-time charge and should be viewed in the context of the long-term benefits.

That means that one should not get a reverse mortgage on a place that one plans to leave in a relatively short time, as little as a year or two or even as much as four or five years, because those fees are gone. But if one plans to stay in the home for several years beyond five, six, or seven or permanently, then it will be amortized over that time. It is a small amount per year. People do tend to stay put. Many people like to, as they say, “Age in place.” For what it is worth, is that I am talking to you from the very same place I have been living in for 45 years. I am 85 now, so I plan to stay. People tend to stay, particularly older people who do not like a change of scene.

One more extraordinary feature is that when a reverse mortgage is taken, in whole or in part, as a line of credit, the portion not yet borrowed grows at the same rate as the portion borrowed accrues interest. That means it grows and grows if one gets a line of credit early on and does not use it for a while. If interest rates are relatively high, remember that it is variable, and the amount available grows.

That becomes extremely important as time goes on. As inflation causes that to grow, the amount available also grows, which helps sustain one’s portfolio.

Myths to clear up.

• The bank does not own the house.
• The heirs do not lose their inheritance.
• The setup fees are low, and incidentally, mortgage insurance premiums are on any regular forward FHA loan.
• It is not true that there is no way out. It can always be paid off or refinanced.
• There are no prepayment penalties.
• There is no equity sharing.
• There are no required annuity purchases.
• The high interest is similar to HELOCs, but HECMs have a lower cap. HELOCs rates are often not capped at all. When inflation and interest rates jump, HELOCs will follow, whereas there is a cap on HECMs.

Concluding Thoughts

A reverse mortgage can constructively divide assets and provide retirement income for people involved in a silver divorce.

In particular, by using a reverse mortgage, both divorcing parties can emerge from the divorce as homeowners with no debt service to erode and constrain their cash outflow for everyday living expenses.

By using a reverse mortgage, divorcing parties can retain a more significant portion of retirement accounts to provide retirement income instead of being drawn down for the division of assets. That is crucial. We are talking about people no longer working, so they cannot refill their retirement funds. A reverse mortgage credit line can serve as a buffer asset to augment and sustain a securities portfolio invested to provide retirement income.