Pay back defaulted loan before new one?

Where does it say that a participant must pay off a defaulted loan before they can take a new one?

What if it was offset after a distributable event?

(Plan allows only one loan at a time)

I am not aware of an explicit rule that says so.  A few thoughts:

Does the plan or loan policy explicitly address this situation?  If yes, follow the plan/loan policy. 

Generally, it is not good loan policy to allow a new loan if an existing loan is in default because:

• A defaulted loan is an outstanding loan.  It continues to accrue interest.  If the plan or plan's loan policy only permits one loan at a time, the defaulted loan is that one loan.
• The Plan Administrator should know about the defaulted loan and likely should not authorize a new loan because the participant is not credit worthy.
• If the plan or loan policy requires that loans must be repaid by payroll deduction, then what would argument would support taking loan repayments for a new loan and not taking loan repayments for the defaulted loan?
• If the participant is an HCE, there is a possibility that the defaulted loan is a prohibited transaction.
• If the additional loan is permissible, then the defaulted loan is taken into account when determining the amount available.

If the loan is offset after a distributable event, then that loan is no longer considered an outstanding loan.  Depending upon the circumstances, this may not get the PA off the hook for authorizing the loan.

If the old loan was offset then I see no problem; it simply doesn't exist (except for the 12 month lookback on the max amount). As far as credit worthiness, I don't want to be the one denying a loan or advising a client to deny a loan for that reason, unless there is some blatant thing to point to like taking a loan 2 months ago and not making any payments. Not that this should matter, but it does: I don't think anybody (IRS) cares as long as you follow the rest of the rules on issuing and defaulting on loans. IMO the reason for having a limit on the number of loans is to create a bright line so that serial defaulters can be denied for something other than subjective creditworthiness.

Whenever we use the term "deemed", we are referring to a legal fiction - we are calling something a thing because the law says we can.  A deemed distribution is just such a fiction.  A deemed distribution is just a taxable event, but it does not end the loan, which continues to exist on the plan's books and continues to accrue interest, impact vesting, outstanding loan balances, etc.  That would prevent a participant from taking a second loan until the first loan is paid off (assuming the plan limits participants to no more than one loan at time).

As Bird notes above, a loan offset distribution terminates the loan.  Once the loan offset occurs, the participant does not have an outstanding participant loan and should be able to take a new loan pursuant to the plan's terms.

The framework for this is found in Treas. Reg. §1.72(p)-1, Q&A 13(a)(2), which provides:

Quote

A deemed distribution is treated as a distribution to the participant or beneficiary only for certain tax purposes and is not a distribution of the accrued benefit. A distribution of a plan loan offset amount (as defined in § 1.402(c)–2, Q&A–9(b)) occurs when, under the terms governing a plan loan, the accrued benefit of the participant or beneficiary is reduced (offset) in order to repay the loan (including the enforcement of the plan's security interest in the accrued benefit).