I need a Primer on taxation of defaulted loans.

[Guest PLHart]

How is defaulted loan taxed. My understanding has been that upon default of loan, the full value of outstanding principal and unpaid interest on default date is deemed distribution and taxable in year of default. Is this correct? After deemed distribution, what happens to additional accrued interest?

[Michael Devault]

Your understanding is correct. Keep in mind that a deemed distribution is for tax purposes only. The plan can't reduce the participant's account balance to clear the loan until a qualifying event occurs, such as separation from service. When that happens, an "offset" distribution is made, whereby the loan balance is actually cleared.

Until that time, interest on the loan continues to accrue and is added to the loan. The participant can pay interest and/or principal after the deemed distribution, which creates cost basis. But, according to proposed regulations, the loan remaining after the deemed distribution is no longer a loan for section 72(p) purposes, meaning that accruing interest doesn't create additional deemed distributions. The remaining loan does, however, have to be included in determining any future loans.

If you have access to them, look at the proposed section 72 regulations. They're in Q&A format and will give you a pretty clear understanding of how loans work.

Hope this if of some benefit to you!