Q. My parents are in their 80’s and could use some financial help to remain in their home. Fortunately, I am in a position to help, but my parents are reluctant to accept gifts. I heard something about a family loan that works like a reverse mortgage. Do you know anything about this?

A.  Yes. It works much like a reverse mortgage from the bank, but can have features that make it a better deal for seniors.

The basic concept of a reverse mortgage is that the lender makes payments to the homeowner as a lump sum, line of credit or stream of monthly payments.  All re-payments of interest and principal are deferred until the homeowner moves out or passes away, at which time the loan is due.

Problem: if a senior moves out of his home into a nursing home to get care, the bank will call the loan due, which may result in a forced sale of the home.  This forced sale could suddenly turn exempt home equity into cash proceeds, potentially making it more difficult for the senior to qualify for a Medi-Cal subsidy. By making qualification for a subsidy more difficult, the forced sale could compel the senior to deplete his own estate by the cost of care.

By contrast, the Private Reverse Mortgage (“PRM”), where the lenders are family members, may better meet the needs of older homeowners.  It works like this: The children loan money to their parents, secured by a deed of trust on the parents’ home. The parents open a new bank account  which the children fund periodically as needed, rather than by way of a lump sum. The parents access that account by writing a check. Just like a bank reverse mortgage, all payments on the loan are deferred until the parents die or the home is sold. However, unlike the bank, the children would not force a sale of the home during their parents’ lifetimes.

Here are some other advantages:

It’s cheaper: the up-front costs of paying an attorney to set up a private reverse mortgage are typically much less than the up-front costs of a bank reverse mortgage; interest rates charged can be lower; and children can lend up to 100% of the home’s value, providing more money for their parents.

The PRM also has advantages for Medi-Cal long-term care planning:

(1) If the senior moves out of the home into a nursing facility, he can still keep the house; a forced sale is avoided and the senior continues to own the home as an exempt asset;

(2) The PRM can help protect the equity in the home for the family: as a secured loan it would take precedence over any claim by Medi-Cal for “payback” following the demise of the senior homeowner;

(3) The PRM can also protect the home equity by permitting a transfer to family members during the senior’s lifetime in order to avoid Medi-Cal “payback” on death, something that would not be permitted by a conventional reverse mortgage lender.

The family of any senior who owns a home, but who has little in savings, should consider the PRM as a way to help parents enjoy the retirement they deserve. Of course, the feasibility of this arrangement assumes that the senior’s family has sufficient means to periodically fund the parents’ drawing account.

Caution:  Depending upon how the note and transaction documents are drawn up, there is the risk that the family “lender(s)” may need to recognize and pay income tax on the accrual of interest each year, even though payment of both principal and interest is not expected until the loan is paid in full, which typically would be when the home is someday sold. This deferred interest is sometimes referred to as “phantom income”, as it has not been actually received.  BUT…..that said, there is IRS authority that if interest is “added monthly to the outstanding loan balance as it accrues“, then the accrued interest is “neither includible in a cash method lender’s gross income nor deductible by a cash method borrower at the time it is added”. IRS Revenue Ruling, Rev. Rul. 80-248 (January 1, 1980).  This older Revenue Ruling still appears to be valid and is in accord with more recent publications from the IRS affirming the deductability to the borrower of deferred reverse mortgage interest in the year of actual payment, as per IRS Publications 554 and 936.  Thus, special care should be observed in drawing up the transaction documents so as to optimize the chance of deferred interest treatment for both lender and borrower under the IRS Revenue Ruling cited above.

Note, further:  there does not appear to be firm IRS authority regarding the treatment of  ‘interest on interest’ when the interest on the outstanding loan principal is thus deferred, added to the loan balance and, itself, accrues interest. Nonetheless, absent a definitive pronouncement from the IRS, most practitioners would treat the “interest on interest” the same way as they treat the underlying deferred interest.

Appreciation to ElderLawAnswers.com for the inspiration for this article and for permission to use portions of its article on the same topic. For more on this topic, see the following article published by CANHR on its website, “CANHR’s Guide to Reverse Mortgage Alternatives Is an Inter-Family Loan Right for You? “