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Loan Terms Originally for Primary Purchase But Deal Fell Through


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Why not repay the loan immediately? Is a new deal expected?

He decided to pay off some debt. To be clear, this is a friend, not a participant of a plan I administer. He said he asked payroll what he should do and they let him decide, which I thought was really strange.

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re-amortize over 5 years or repay the loan. the loan he has is NOT for the purchase of a principal residence and does not qualify for the extension past 5 years. One of the many reasons a some plans don't allow loans more than 5 years, even for home purchase. They are simply too much of a head ache for some folks.

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Pardon my jumping in, but at the time he took the loan, it was for the purchase of a principle residence. Is not what he actually does with the money less relevant to the discussion? For many types of transaction, we typically look to the conditions that exist at the time of the transaction, not subsequent events.

I suppose if a plan sponsor wanted to be exceedingly cautious, they could have insisted on having the plan loan held in escrow pending closing just like other financing for the purchase of real estate - but that would be an incredible pain in the you know what....

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Pardon my jumping in, but at the time he took the loan, it was for the purchase of a principle residence. Is not what he actually does with the money less relevant to the discussion? For many types of transaction, we typically look to the conditions that exist at the time of the transaction, not subsequent events.

I suppose if a plan sponsor wanted to be exceedingly cautious, they could have insisted on having the plan loan held in escrow pending closing just like other financing for the purchase of real estate - but that would be an incredible pain in the you know what....

While I agree with you in theory, he went back to HR to tell them the loan was not used for a primary residence purchase. Does this change your reaction?

I'm also looking at it from his perspective. Suppose the IRS found this during an audit. Couldn't they determine that it wasn't for a house and declare any principal paid after 5 years should be taxable? I don't think they would actually find it if the original paperwork were completed, but it's a possibility, correct?

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Pardon my jumping in, but at the time he took the loan, it was for the purchase of a principle residence. Is not what he actually does with the money less relevant to the discussion? For many types of transaction, we typically look to the conditions that exist at the time of the transaction, not subsequent events.

I suppose if a plan sponsor wanted to be exceedingly cautious, they could have insisted on having the plan loan held in escrow pending closing just like other financing for the purchase of real estate - but that would be an incredible pain in the you know what....

While I agree with you in theory, he went back to HR to tell them the loan was not used for a primary residence purchase. Does this change your reaction?

I'm also looking at it from his perspective. Suppose the IRS found this during an audit. Couldn't they determine that it wasn't for a house and declare any principal paid after 5 years should be taxable? I don't think they would actually find it if the original paperwork were completed, but it's a possibility, correct?

If the loan had already been finalized by the time he told them, then my reaction hasn't changed. I think the plan sponsor should do what they normally do with loans of this type - KEEP THE DOCUMENTATION on which they granted the loan.... If asked, they can, truthfully say, they followed procedure and protocol, and once the check was in the hands of the participant, it's not their problem. If the documentation doesn't exist that shows it was intended for the purchase of a principle residence, well, then that is a different story and the plan sponsor has bigger issues.....

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I'd suggest taking a look at the loan program's language and any language buried in the loan application/terms to see if it sheds any light on the matter. I've seen these kinds of documents with language that says "if you don't use it for a principal residence purchase, you have to tell the plan administrator and make arrangements to reamortize over a 5 year (or shorter) period." Ability to enforce that is certainly up in the air, but I have seen sponsors search for cover on this topic by placing an obligation on the participant to tidy up if the deal falls through.

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Is it the board's opinion that IF the participant is found out by the IRS about this situation, he could be liable for taxes on the principal amount remaining after 5 years, even though he has paperwork from the plan sponsor indicating a 30 year am schedule?

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This link:

http://www.irs.gov/Retirement-Plans/401(k)-Plan-Fix-It-Guide-Participant-loans-do-not-conform-to-the-requirements-of-the-plan-document-and-IRC-section-72(p).

says that the loan must be used to purchase a main home in order for the loan to go for more than 5 years.

Since it says "used" and does not say "intended to be used" to purchase a main home, I'd suggest that the participant rework the loan to the 5 year limit, or buy another house soon.

As Searchlight said, the loan documents may say what happens in this case. Since the Plan has enough banking experience (in house or on call) to think that they can offer and process loans, surely they put wording into the plan or the loan document to address a potential situation as obvious as this.

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Is it the board's opinion that IF the participant is found out by the IRS about this situation, he could be liable for taxes on the principal amount remaining after 5 years, even though he has paperwork from the plan sponsor indicating a 30 year am schedule?

I think the worst case would be worse than that. Under 1.72(p)-1, Q&A 4(a), the loan becomes a deemed distribution at the time the loan first fails to satisfy the loan rules. If the loan doesn't qualify for a longer than 5 year amortization, the 30 year amortization fails to satisfy the repayment term requirement of 72(p)(2)(B). I think in this case that would happen when the deal on the house fell through, not after 5 years. Depending on the plan's loan provisions, the cure period might buy him a few months to reamortize over the remainder of the 5 years before the loan is deemed.

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Why not repay the loan immediately? Is a new deal expected?

He decided to pay off some debt. To be clear, this is a friend, not a participant of a plan I administer. He said he asked payroll what he should do and they let him decide, which I thought was really strange.

If he paid off "some" debt, he should have a substantial amount left from the loan. What if he takes the remaining amount of the loan after paying "some" debt, pay down the loan by that amount, and reamortize the remaining balance for 5 years (or less). Then he is actually financing his "some" debt.

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Why not repay the loan immediately? Is a new deal expected?

He decided to pay off some debt. To be clear, this is a friend, not a participant of a plan I administer. He said he asked payroll what he should do and they let him decide, which I thought was really strange.

If he paid off "some" debt, he should have a substantial amount left from the loan. What if he takes the remaining amount of the loan after paying "some" debt, pay down the loan by that amount, and reamortize the remaining balance for 5 years (or less). Then he is actually financing his "some" debt.

He has the ability to pay the loan back even though he spent some. This situation came up when he was asking me if I thought he should invest the remaining loan balance that he didn't use to pay off debt. I've never encountered this situation but I told him it didn't sound right. The problem is he doesn't think it's an issue because his company wasn't worried about it. I'm trying to get him to see that he has created a situation that could cost him down the road, but he keeps going back to the fact that the sponsor wasn't concerned.

He thinks I'm making a big deal over a non-issue.

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He thinks I'm making a big deal over a non-issue.


To some degree my guess is he is correct. Not that I think the law is on his side-- it isn't in my opinion. But in order for this to blow up in his fact either the plan or he would have to be audited. In his case the year he got the money is probably the only time the transaction would get noted. That is a low risk.

In case of the plan while any time while the loan is in existence the audit would detect the loan as long as the administrator pulled out the documents showing it was giving in good faith for a home purchase my guess the IRS agent isn't going to ask for the person to prove they bought the house. The more years after the loan was issued the more I think that is true. So that is a low risk.

In short the odds of this guy getting caught in my opinion is very low. Do I ever recommend someone to play the audit lottery? No. But the reality is my guess if you had a 100 people do this 99 to 100 of them would never get in trouble. That could be seen as a big deal over a non-issue.

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He thinks I'm making a big deal over a non-issue.

To some degree my guess is he is correct. Not that I think the law is on his side-- it isn't in my opinion. But in order for this to blow up in his fact either the plan or he would have to be audited. In his case the year he got the money is probably the only time the transaction would get noted. That is a low risk.

In case of the plan while any time while the loan is in existence the audit would detect the loan as long as the administrator pulled out the documents showing it was giving in good faith for a home purchase my guess the IRS agent isn't going to ask for the person to prove they bought the house. The more years after the loan was issued the more I think that is true. So that is a low risk.

In short the odds of this guy getting caught in my opinion is very low. Do I ever recommend someone to play the audit lottery? No. But the reality is my guess if you had a 100 people do this 99 to 100 of them would never get in trouble. That could be seen as a big deal over a non-issue.

Yes, I let him know this as well, especially since the sponsor has clean paperwork supporting the purchase. My summary point was yes, there are tiny odds he would ever get caught but what he is doing is likely not allowed, and could cause him a financial issue down the road. If the money isn't needed for an emergency situation, why risk it?

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Low audit risk is one thing. Following the plan document might be another.

The plan administrator should consider the cautions raised in Post # 9.

I'm a retirement actuary. Nothing about my comments is intended or should be construed as investment, tax, legal or accounting advice. Occasionally, but not all the time, it might be reasonable to interpret my comments as actuarial or consulting advice.

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Under 1.72(p)-1, Q&A 4(a), the loan becomes a deemed distribution at the time the loan first fails to satisfy the loan rules. If the loan doesn't qualify for a longer than 5 year amortization, the 30 year amortization fails to satisfy the repayment term requirement of 72(p)(2)(B).

If the loan in the OP should be deemed, but isn't deemed, is the plan in trouble or the participant? Just curious.

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