Is this loan really to pay for the purchase of a primary residence?

[AlbanyConsultant]

Hi.  We received a loan request where the participant is looking to extend the loan repayment period past 5 years because he is buying a primary residence.  He sent us a mortgage contract to prove that this was happening.

In the contract, it states that "This Agreement is contingent upon Purchaser obtaining approval of a FHA mortgage loan of $X...", where $X is the amount of the purchase less deposit plus closing costs.  The amount being requested as a plan loan is more than the deposit amount.

So... is the loan actually used towards the purchase of the primary residence or not?  If the Purchaser must get a mortgage to cover the entire cost, then the loan is just replenishing his bank account (except maybe for the down payment amount).  Or, as I suspect, this is just an example of language being stupid and inexact and we all know what the heck is supposed to be happening, so it's fine?

Thanks!

[TPAJake]

I think you're trying to apply hardship approval concepts to a mortgage loan situation.  They have different requirements in documentation & for extended amortization there is no duty to ensure that the amount requested corresponds to the amount of need.  If they have enough money, provided a legit sales contract & the document allows it, it's good.  

However, in this case, I agree that language is iffy & sounds like they just came straight to you from the model home without doing any actual mortgage app.  I might ask for a good faith estimate from the lender to go along with that sales contract.  Asking for a GFE requires them to have a few things finished at the lender & their 401k funds aren't going anywhere in the next few weeks.  I don't like people coming for mortgage-related withdrawals a day or 2 after dropping their $500 earnest money--They still have a long way to go in the process & if this is their first home, they're usually jumping the gun on the amount they'll actually need for closing costs.  

I give them a call, congratulate them on their big decision, try to make them feel special & let them know the money is here when they're ready, but you need to know their actual closing date.  If it's next week, they have something better than a sales contract for your records.  If it's 30 or 45 days away,  they have plenty of time.  

[RatherBeGolfing]

1 hour ago, TPAJake said:

 

...there is no duty to ensure that the amount requested corresponds to the amount of need.  If they have enough money, provided a legit sales contract & the document allows it, it's good.  

 

So you approve loans amortized over more than 5 years based on what?

[AlbanyConsultant]

I did speak to the participant's attorney to get clarification, and he said that the contract is going to be revised to non-FHA anyway, so this is a moot point.  He confirmed that the participant definitely wants to use the loan proceeds as part of the purchase transaction.

 

So, false alarm.  Or, as I like to call it, "Scramble to do a bunch of hyper-specific research that will not be applicable when the facts change 24 hours later." LOL

[RatherBeGolfing]

14 minutes ago, AlbanyConsultant said:

So, false alarm.  Or, as I like to call it, "Scramble to do a bunch of hyper-specific research that will not be applicable when the facts change 24 hours later." LOL

Sure, but your headaches still make for interesting discussion starters for the rest of us 

[TPAJake]

13 hours ago, RatherBeGolfing said:

So you approve loans amortized over more than 5 years based on what?

Based on the fact that he is purchasing a principal residence & therefore qualifies for the extended amortization, which I have the documents to prove.  Like our previous discussion, if he uses that money for something else, that's outside of my control--I have a complete file.  

[RatherBeGolfing]

28 minutes ago, TPAJake said:

Based on the fact that he is purchasing a principal residence & therefore qualifies for the extended amortization, which I have the documents to prove.  Like our previous discussion, if he uses that money for something else, that's outside of my control--I have a complete file.  

Ok so in your opinion the actual costs incident to the acquisition of a principal residence are irrelevant?  

 

[TPAJake]

Correct, that is my opinion--If you want to borrow $50k over 6 years or more (and the plan doc allows that), I don't care how much your house is going to cost or how much you need to close, I only care that you provide me proof of the home purchase.  Unless there's some new & improved guidance I haven't seen, IRS is silent on amount, their requirements center around purpose & documentation to justify extended amortization. 

That is in stark contrast to requesting a hardship for the same home purchase.  In the case of hardship I do have to verify that the amount requested is necessary to satisfy the need. 

The rub:

$25k loan request for a $100k house & you only need $10k to close, yes you get your loan & extended amortization.

$25k hardship request for a $100k house & you only need $10k to close, no you only get the $10k.

[Belgarath]

Hmmm - I'm not so sure about that. 1.72(p)1, Q&A-7 refer you to the "tracing rules" in 163(h)(3)(B). As I read those rules, if you can't prove that the funds were actually used in "acquiring, constructing, or substantially improving" the qualified residence, then I don't necessarily think it qualifies. So, if you buy a house for $200,000, and take a mortgage loan from the bank for $180,000, and said loan is secured by the residence, and you additionally take a $50,000 loan from your plan, and use $20,000 for the difference, and then spend the other $30,000 on a trip to Monaco, do you think this qualifies? More to the point, do you think the IRS would agree? Just curious.

[RatherBeGolfing]

Belgarath points to the same concern I have here.  If the loan terms exceed 5 years and it does not qualify as a principal residence loan, you fail to satisfy IRC §72(p)and the consequence is a deemed distribution or VCP to correct. 

Whether the loan qualifies as a principal residence loan is not a needs tests like in a hardship situation, it is a best practices issue to make sure that you do not issue loans in violation of IRC §72(p) that could be detrimental to the plan and participant. 

 

[TPAJake]

I agree with you from a philosophical standpoint but during the approval process, how could you possibly prove that the funds will actually be used in acquiring or constructing the qualified residence?  You would need a time machine, because people do stupid things after you give them money.    

[RatherBeGolfing]

 

24 minutes ago, TPAJake said:

I agree with you from a philosophical standpoint but during the approval process, how could you possibly prove that the funds will actually be used in acquiring or constructing the qualified residence?  You would need a time machine, because people do stupid things after you give them money.    

There is nothing philosophical about 72(p).  If you approve a a loan in excess of the costs that can qualify for a principal residency loan, you are 100% guaranteed to violate 72(p).  No time machine needed.

[TPAJake]

So let's follow your logic then, using my example from earlier:

 $25k loan request for a $100k house & you only need $10k to close, I deny the extended amortization on $25k.  If you only want $10k, I can let you pay out to 10 years, but if you want $25k, you have to pay it back within 5 years.  

In the real world where I'm talking to people who loathe the IRS, a few possibilities exist for what happens next.  Most likely I get a fresh set of closing docs showing they need $25k to close & I wasted everyone's time denying it the first time.  Option 2 is they agree to the 5 year repayment schedule, the mortgage underwriter sees that new debt obligation, decides it's too high & refuses to approve closing, deal falls through.  The third possibility is they decide to take a hardship for the $10k instead & that money never gets back into the Plan.  I'm sure there are more I can't think of right now, but you get the picture, there's no upside to splitting hairs about how much they really need for a rez loan.  If the IRS challenges extended amortization 3 or 4 years later, or an auditor asks for documentation the next year--Here's the sales contract & the Participant's phone number so you can ask them what they really did with the money.  

I'm no Attorney & my job is to be the solutions side of the K industry, so I do end up oversimplifying things sometimes.  I appreciate these conversations because they remind me of just how intricate the rules are in print.  Just because I've never had the IRS, DOL or an auditor disagree with one of my transactions before does not mean it will never happen!    

 

[RatherBeGolfing]

Yes, the law is inconvenient at times

[TPAJake]

Got that right!  I can't tell you how many times I've heard "the law says I can take a loan from my 401k, what do you mean THIS plan doesn't allow loans?" or my personal favorite "I just want to close out my 401k, it's my money"  

[Doghouse]

The following from this IRS article is interesting:

Keep documentation on plan loans

A plan sponsor should retain these records, in paper or electronic format, for each plan loan granted to a participant:

1. Evidence of the loan application, review and approval process.
2. An executed plan loan note.
3. If applicable, documentation verifying that the loan proceeds were used to purchase or construct a primary residence.
4. Evidence of loan repayments.
5. Evidence of collection activities for defaulted loans and related Forms 1099-R, if applicable.

If a participant requests a loan with a repayment period in excess of five years for the purpose of purchasing or constructing a primary residence, the plan sponsor must obtain documentation of the home purchase before the loan is approved. IRS audits have found that some plan administrators impermissibly allowed participants to self-certify their eligibility for these loans.

[TPAJake]

Absolutely, but there's that time machine problem again in step 3--They use "were" rather than "will be".  The note is already written & signed by that point.  

Besides, if they used a few bucks to fill the house with furniture & buy a new refrigerator,  they still used the proceeds to purchase the house first.  And it does not say that 100% of the loan proceeds must be used to purchase or construct a primary residence.  Purpose & documentation are very explicit, but not amount.

[RatherBeGolfing]

15 minutes ago, TPAJake said:

Absolutely, but there's that time machine problem again in step 3--They use "were" rather than "will be".  The note is already written & signed by that point.  

Besides, if they used a few bucks to fill the house with furniture & buy a new refrigerator,  they still used the proceeds to purchase the house first.  And it does not say that 100% of the loan proceeds must be used to purchase or construct a primary residence.  Purpose & documentation are very explicit, but not amount.

By that logic, you could use someone else's loan note as proof because the law doesn't specifically say it has to be YOUR loan note.

[TPAJake]

Oh wow, that's a really good point!  I think we touched on a similar situation a while back in a different thread relating to a hardship for eviction in a domestic partnership situation, where the wrong party was on the lease.  I won't be approving any residential loans for John using Bill's GFE though, I promise. 

[ricopenthouse]

When taking a loan always consult a lawyer beforehand. I got burned once, thankfully it was a small loan but I paid back double nonetheless. I have a small business and owning one involves taking many loans from the bank. I have made it a rule of mine to always consult with a specialist from Mortgage Broker Essex before and during the visit to the bank. They can't deceive you legally and they throw a bunch of fancy and complicated words in the contract so you do the self deceiving part.