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