Home Loans Using Retirement Plan Funds
by Verne F. Moser, CPA
March 1998
The Taxpayer Relief Act of 1997 increased taxpayers ability to use retirement plan funds for the purchase of real estate by adding certain IRA funds to the list. Also of interest to most of us, the new tax act added significantly to the types of IRA's available to taxpayers and increased substantially the adjusted gross income levels before IRA contributions are not allowed (phased out). Hence, taxpayers should be able to make more IRA contributions than in the past which under certain conditions can be used for new housing acquisition costs.
I. IRA Distributions
Prior to the 1997 Act, distributions from an IRA to participants before they reached the age of 59 1/2 were generally subject to a 10% penalty as well as the distribution itself being included in the taxpayer's taxable income. Under the new law, one of the exceptions to this is a first-time home buyers distribution made after December 31, 1997. Qualified first-time home buyer distributions are withdrawals (not loans that have to be repaid) of up $10,000 made during the individual's lifetime for qualified acquisitions costs of purchasing a principal residence for an individual that the new law defines as a first-time home buyer. Definitions of these two requirements are as follows:
Qualified Acquisition Costs: the cost of acquiring, constructing or reconstructing a principal residence. These costs can also include reasonable closing costs such as settlement fees, financing or other closing costs. The total of all of these allowable costs cannot exceed $10,000 during the individual's lifetime. Funds withdrawn from an IRA must be used within 120 days from the date the distribution is received by the individual who is borrowing from the IRA. The new law defines the date of acquisition (the event that must occur by the end of the 120 day period) as the date 1) when a binding contract to purchase the principal residence is signed or 2) the dated construction or reconstruction actually begins. If circumstances cause events 1 or 2 to be delayed beyond the 120 period, the IRA funds can be repaid to the IRA to escape the tax and 10% penalty on the funds withdrawn. In this situation, the $10,000 maximum distribution can then be made when the new date of acquisition is established.
First-time home buyer: an individual (including any spouse) who has had no ownership interest in a principal residence during the two-year period immediately prior to the date of acquisition of the home being purchased with the IRA funds. The funds may also be used for qualified acquisition costs of the individual's child, grandchild or ancestor of the individual or spouse as long as these relatives meet the first-time home buyer qualifications. In summary, a first-time home buyer is not someone who has never owned a principal residence; just someone (and his spouse if married) who has not owned a principal residence in the past two years.
II. Loan from Qualified Plans
Qualified retirement plans are generally those that are sponsored by an employer, such as a defined benefit plan, defined contribution plan, 401(k) plans or Simple 401(K) plans. Employee sponsored plans such as union retirement plans also qualify for such loans. Keep in mind that while the law allows loans to be made if certain restrictions are met, the plan itself must also allow for loans as part of its terms and conditions. Plans can be modified to allow for a loan program but these modifications have to be submitted to the IRS. This generally includes the use of a firm or individual specializing in preparing plan documents with a related cost of professional fees being incurred.
Qualified Plan Loan Rules:
The general provisions to be met in order for the distribution not to be considered taxable are as follows:
- The plan must allow loans.
- The maximum amount of any loan balance is 50% of the individual's vested benefits.
- The loan must have a commercially reasonable interest rate (a rate equal to a similar loan from some commercial lending institution).
- The note must be legally enforceable. Generally, a note signed by the individual and spouse.
- The term of the loan must not be longer than 5 years and periodic payments must be made.
A caution here: an event that can lead to a deemed early distribution subject to the tax and penalty is to either pledge or assign an interest in a plan that is used to secure a loan of a participant. Further, if a participant agrees to such a pledge, without formally making the assignment or pledge, such agreement will be deemed a distribution.
Qualified Principal Residence exception:
When a loan is made for the purpose of acquiring a principal residence, the 5-year limit is waived. Where the proceeds are used for a principal residence, the term can be that commercially used for such loans. An example provided by the Internal Revenue Code is an individual borrows $50,000 from a bank for a period of 15 years and uses the funds as a down payment on a home. The individual then borrows funds from his plan to repay the bank loan. The terms of the loan from the plan would be those offered by the bank.
Other rules to be observed for principal residence loans are as follows:
- The principal residence is for the individual and spouse only, not related parties as is the case with IRA funds.
- Principal residence loans do not have to be secured by the real estate. However, they are subject to the tracing rules. These rules generally state that the funds must be able to be traced from the loan proceeds directly to the use of funds to purchase a principal residence. An example of a tracing of funds that indirectly are used to purchase a residence is the example given above.
- Refinancing of an existing principal residence is not a qualified loan. The example given in the opening paragraph is not considered refinancing.
Finally, one other exception to the repayment rules exists: an individual on leave of absence from his/her employer for up to one year can defer the payments during the leave of absence if 1) the individual receives no pay or 2) the monthly pay amount is less than the loan installment amount. However, the delayed payments must be paid by the end of the original agreed upon term of the loan.
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