4064 / How long can a loan under a tax sheltered annuity remain outstanding and still avoid treatment as a deemed distribution and inclusion in the participant’s taxable income?
To avoid treatment as a deemed distribution, a loan by its terms must be required to be repaid within five years. A loan used to acquire a dwelling that within a reasonable time is to be used as the participant’s principal residence (as defined in IRC Section 121) is not subject to the five year repayment term requirement.1 Although the IRC puts no specific limit on the term of principal residence loans, it is likely that the IRS will impose at least a reasonable term on the theory that a loan is not in fact a loan if there is no obligation to repay.2 A loan need not be secured by the dwelling that is to be the participant’s principal residence to qualify as a principal residence loan exempt from the five year term requirement,3 but see Q 4073 if there is a desire to render the interest on the loan deductible as qualified residence interest.
Tracing rules under IRC Section 163(h)(3)(B) apply in determining whether a loan is treated as for the acquisition of a principal residence and, therefore, exempt from the five year term requirement.4
Finally, a refinancing generally cannot qualify as a principal residence loan exempt from the five year term requirement. A loan used to repay a loan from a third party will qualify as a principal residence loan if it qualifies as such a loan without regard to the loan from the third party.5
1. IRC § 72(p)(2)(B); Treas. Reg. § 1.72(p)-1, A-5.