Know the tax implications of reverse mortgage transactions

Last week, we have discussed the salient features of a reverse mortgage scheme. I feel that unless the tax implications are fully understood, one would not be able to decide whether he should opt for reverse mortgage scheme to supplement his cash flow in retirement and which option to exercise. In this article I wish to discuss the tax implications of all the transactions involved under reverse mortgage scheme in two different options at different stages.

Tax implications for money received from the lender directly

As per the Indian tax laws any surplus realized on "transfer" of a capital assets is treated as capital gain and taxed differently based the nature of the asset and holding period of the asset. Section 47((xvi) of Income Tax act, 1961 defines as to what is a a transfer and includes any sale, relinquishment, exchange, extinguishments of rights etc. of any asset. Since the transaction of mortgaging a property which includes mortgage under the reverse mortgage scheme is not treated as transfer as envisaged by the tax laws, there is no tax liability at the time of mortgaging the house with the bank under this scheme.

Please note that though no tax incidence occurs at the time of mortgaging the house but if and when the house is sold whether by the lender or the senior citizen himself or the legal heirs, the transaction comes within the definition of transfer and is taxed accordingly. It is taxed in the hands of the senior citizen if he is alive and in the hands of legal heirs if the borrower has passed away. Please note that if the borrower or his legal heirs pay up the outstanding balance under the under the scheme, there is not tax liability in such situation, as there is no transfer of house yet.

For the money received from lender whether as lump sum or in installments, there is a specific exemption provided under Section 10(43) of the Income Tax Act , 1961 in respect of such receipts.

So there are no tax implications under the pure reverse mortgage schemes as well as long as the property is not sold by any of the parties.

Tax implications under the annuity option from life insurance Company

As discussed in the previous article, the senior citizen may opt to buy an annuity from a life insurance company instead of opting to receive money from the lender directly. Under such situation in consideration of the senior citizen mortgaging the property in favour of the bank, the bank hands over a lump sum to the insurance company. This transaction of handing over the lump sum money to the insurance company does not give rise to any tax liability as this transaction is part of the mortgage transaction and mortgage is not a transfer as per the income tax laws as explained above.

Under the second type reverse mortgage transaction under the scheme, the life insurance company agrees to make periodic payments to the borrower. Such payments by the insurance company are treated as annuity and is treated as income under the Income Tax laws. Such annuity received from a life insurance company is taxed under the head "Income From Other Sources".

Though some amendments were made in the Reverse Mortgage Scheme 2008, in 2013 to provide for exemption for payment of lump sum amount by the lender to the life insurance companies under the scheme, there were no corresponding amendments in Section 10(43) to make the payment of annuity received from life insurance companies as exempt. So the annuity received under this scheme continues to remain taxable in the hands of the senior citizen.

So for the same type of benefit contemplated under the scheme, the tax treatment is different depending on whether you opt for receipt of money from the lender himself or from the life insurance company, which in my opinion is not fair. As the purpose of the reverse mortgage scheme is to help the borrowers supplement their cash flows, it seems unreasonable to extract tax from the hapless senior citizens out of the money which is supposed to help them meet their day today expenses in difficult phase of their life.

The option of taking annuity from life insurance company under this scheme can help the senior citizens continued in flow for their the remaining lifetime, without there being any restriction of 20 years as applicable for pure reverse mortgage schemes, the same needs to be made more attractive for the senior citizens.

Moreover as the scheme has not taken off well, I would urge the government to amend the tax laws to provide for exemption for annuity received from an insurance company under the reverse mortgage scheme.

I am sure the reader are now in a position to understand the tax implications of such a good scheme as Reverse Mortgage Scheme.

The writer is a tax and investments expert