4070 / Can loans taken under a tax sheltered annuity be refinanced? What is the effect of a refinancing on determining whether the outstanding loans constitute deemed distributions?

A refinancing transaction is any transaction in which one loan replaces another. For example, a refinancing may exist if the outstanding loan amount is increased or if the interest rate or the repayment term of the loan is renegotiated.¹

If the term of a replacement loan ends after the latest permissible term of the loan it replaces, then both loans are treated as outstanding on the date of the refinancing transaction. This generally means that the loans must collectively satisfy the requirements of IRC Section 72(p) when determining whether the loans will constitute deemed distributions.²

There is an exception where the replacement loan would satisfy IRC Section 72(p)(2) if it were treated as two separate loans. Under this exception, the amount of the replaced loan, amortized in substantially level payments over a period ending not later than the last day of the latest permissible term of the replaced loan, is treated as one loan. The other loan is for an amount equal to the difference between the amount of the replacement loan and the outstanding balance of the replaced loan.³

The IRS will not view the transaction as circumventing IRC Section 72(p) provided that the replacement loan effectively amortizes an amount equal to the replaced loan over a period ending not later than the last day of the latest permissible term of the replaced loan. For this reason, the outstanding balance of the replaced loan need not be taken into account in determining whether the limitations of IRC Section 72(p)(2) have been met; only the amount of the replacement loan plus any existing loans that are not being replaced are considered.⁴

If the term of a replacement loan does not end later than the latest permissible term of the replaced loan, then only the amount of the replacement loan plus the outstanding balance of any existing loans that are not being replaced must be taken into account in determining whether IRC Section 72(p) has been satisfied.⁵