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Let's be mindful that a loan to a participant is an asset of the plan. The loan may be a general asset or may be earmarked as an asset to the participant. Since most loans are from individual account plans and are earmarked as an asset of the participant, most discussions of loans assume that loan rules are solely between the individual and the plan. Let's recast the conversion from the perspective of a loan as a plan asset: A participant takes out a loan from the plan. The participant gets cash and the plan gets a promissory note. The participant makes repayments that include principal and interest. The principal repayment reduces the outstanding principal on the promissory note and the interest is income to the plan. All is in balance. The participant stops making repayments on the loan. The principal on the promissory note no longer is being repaid, and the plan no longer is receiving interest as income to the plan. The loan goes into default and the outstanding amount of the promissory note is declared a deemed distribution and reported as taxable to the participant (after all, the participant effectively still has the "cash" from the remaining original principal of the loan): The plan still hold the promissory note for the remaining outstanding principal. According to the terms of the promissory note, this outstanding principal continues to accrue interest effectively increasing the amount due to the plan from the participant. If the plan loan is earmarked to the participant, the plan remains an asset in the participant's account. If the plan loan is not earmarked to the participant, the participant's accrued benefit is not affected. If the loan is offset (say the participant terminates employment): The promissory note is worthless as a plan asset that the associated accrued interest and the remaining loan principal are written off by the plan as an investment loss. After the deemed distribution, the participant never repaid any additional principal or interest, and the participant does not receive any additional distribution on the amount of the loan offset. The participant's account balance is reduced by the amount of the remaining outstanding principal. The participant does not receive any of the interest that was accrued on the deemed loan. In effect, for the participant with an earmarked loan, the participant bears the investment loss applied against this accrued interest. If the loan was not earmarked as an asset for the participant, the plan bears the investment loss. Let's now consider what happens if the participant remains active and begins making loan repayments for the deemed loan: The plan begins to credit repayments of principal and interest against outstanding balance of the promissory note that includes the interest that accrued after the loan was declared a deemed distribution. The amount of the deemed distribution is considered as after-tax basis for the participant. The interest on these repayments is treated no differently that the way interest was treated before the deemed distribution. It is interest received as income to the plan. The interest repaid by the participant does not create additional basis in the account (just like how income on after-tax contributions does not create additional basis for the participant). Some loan policies may address the plan accounting which can impact the accounting of the above scenarios, but these policies should not create additional basis for the participant. Practitioners who have many, many years in the business may remember when interest on personal loans, credit card interest, and interest on plan loans were all deductible. Those were the days where loan interest was the equivalent of a pre-tax deferral.

Recognizing RatherBeGolfing’s observation that the truth might not be one-sided: If you help uncover the past, get the plan sponsor/administrator’s attorney to engage you to assist her. That way, what you communicate to the attorney can be shielded under evidence-law privileges for lawyer-client communications and attorney work product.

It's not taxable at time of offset. Which means your second sentence is accurate; it is only used for applying limits (and in fact the loan exists so if the limit is one per participant it counts as a loan and another one can't be taken).

My understanding is that the loan still exists, it was just taxable as a deemed distribution, which is different than a distribution/offset where the loan is actually "distributed" and no longer in the plan - but I defer to others who deal with this more regularly, as I do not. This all ignores the prudency and possible other concerns lending to someone who recently defaulted. Again, not my area so I'll others argue any issues there.