401k Home Mortgage Loans

[Guest batberf]

Can a 401k loan (interest payments made on the loan) secured by a primary residence be tax-deductible in the year the loan payments are made (just like a regular home mortgage deduction)?

If so, what are the requirements to make this loan conform to the home mortgage tax-deductibility requirements by the IRS?

Must a lien be filed against the house? Must the 401k administrator report interest paid to the IRS? Are there any requirements either I or the 401k plan administrator must follow?

I want to avoid paying the interest part of the loan back with after-tax money, then pay taxes on the interest portion of the money again when I withdraw the money from the plan some years into the future.

[Guest dmj1998]

batberf - this is generally not possible. most 401k loans are set-up to be secured by the participant's interest in the assets in the plan, so unless your home is considered a plan asset, probably not.

I saw a reference to an IRS letter ruling - 8933018, that might give you some ideas, but I couldn't find it anywhere in a brief search of the web. If you find it, I'd appreciate if you could let me know where.

with regard to the double-taxation on the interest paid, that is one of the downsides of the 401k loan that few participants realize when loans are initiated. unless you are successful with your first quest to get the interest payments to be tax deductible, you're going to have to live with this one.

[QDROphile]

As long as your plan document allows homes as security, you can do it. The mortgage can be in addition to the account as security. But this is playing with fire because the mortgage interest deduction rules are complicated, and 401(k) plans add an additional twist. I won't even tell you about that trap (and it is a big one) because you should not play this game without specific competent professional advice. I have seen lots of trouble because of a faliure to meet some requirement, whether or not the requirement related to the plan. Mortgage interest dedutions are on the IRS auditor's list for audits of personal tax returns and people who make mistakes get caught. Also, in the event of defualt, the plan will have to foreclose on the mortgage. Are your really ready to do that?

[Steve72]

FYI

Private Letter Ruling 8933018

Full Text:

May 19, 1989

This is in reply to your request for a private letter ruling in a letter dated December 2, 1988, submitted on your behalf by your authorized representative. Your ruling requests concern the federal income tax consequences of certain plan loans secured by real estate.

Company M maintains two profit sharing plans, Plan X and Plan Y. Plan X was adopted effective January 1, 1987. Company M has applied for a determination letter as to the qualified status of Plan X under section 401(a) of the Internal Revenue Code.

Plan Y, established effective January 2, 1982, includes a cash or deferred arrangement (CODA) under section 401(k) of the Code providing for elective deferrals. Company M has received favorable determination letters on the qualified status of Plan Y under sections 401(a) and 401(k).

Both Plans permit participants to borrow money from their accounts. The Plans set the terms and conditions that all loans must meet under the Plan to satisfy the requirements of section 72(p).

Company M proposes to amend Plan X and Plan Y to allow participants to borrow from their account for the purchase or construction of their principal residences and have the loan secured by a recorded deed of trust on that residence. The participant's Plan X and Plan Y account balance will not be used as security for such loan.

In addition to certain other requirements, the Plans provide that -- each loan will be available to all members on a non- discriminatory and reasonably equivalent basis; each loan shall bear a reasonable rate of interest; each loan shall be repaid over not more than five years from the date the loan is made, unless the loan will be used to acquire any dwelling unit which is to be used as the principal residence (within the meaning of section 1034), in which case the terms of the promissory note shall require repayment over no more than a specified number of years; each loan shall be repaid on a level amortization basis, and payment made no less often than quarterly; each loan shall be evidenced by a written promissory note; and each loan shall be adequately secured.

Based on these representations, you request the following rulings:

1. Assuming that the terms of the proposed amendments to Plans X and Y are complied with, interest paid by a member on a residential loan from Plan X or Plan Y will be “qualified residence interest” secured by a qualified residence under section 163(h)(3) of the Code and therefore, subject to applicable statutory limitations, deductible under section 163 by the member to whom the residential loan is made.

2. The limitation on the deductibility of interest contained in section 72(p)(3) of the Code will not apply to residential loans from Plan Y except with respect to interest paid on residential loans made to key employees.

Ruling request one has been referred to the Chief Counsel, Income Tax and Accounting Division for their consideration and reply.

With respect to the second ruling request, section 72(p)(2)(A) of the Code provides generally that a loan will not be considered to be a taxable distribution to the extent that such loan -- (when added to the outstanding balance of all the loans from such plan) does not exceed the lesser of (i) $ 50,000, or (ii) the greater of 1/2 of the present value of the nonforfeitable accrued benefit of the employee under the plan, or $ 10,000; is repaid within 5 years, except for certain loans used to acquire any personal residence; and is repaid in at least quarterly level amortization payments.

Section 72(p)(3)(A) of the Code disallows a deduction for interest paid on plan loans to key employees (as defined in section 416(i)), or if such loan is secured by amounts attributable to elective 401(k) or 403(B) deferrals (as defined in section 402(g)(3)).

In this case residential loans obtained by Plan Y participants will be secured by a deed of trust and not by amounts attributable to elective 401(k) deferrals. Based upon this representation, we conclude, with respect to your second ruling request, that the disallowance of the interest deduction set forth in section 72(p)(3) of the Code will not apply to residential loans from Plan Y except with respect to interest paid on residential loans made to key employees.

The above ruling is based on the assumption that the proposed loan is a bona fide loan as defined in section 4975(d)(1) of the Code, made in accordance with section 72(p)(2) and that Plan Y will be qualified under sections 401(a) and section 401(k) and the related trust will be tax-exempt under section 501(a) at all times pertinent to this ruling request. In addition, this ruling does not address any issues with respect to section 163(h) of the Code.

In accordance with a power of attorney on file with this office, a copy of this ruling is being sent to your authorized representative.