Principal residence

blue_velvet_elvisFebruary 21, 2007

My husband and I owe about 14k on a house we've been buying on contract that's next door to our regular home. I have almost that much in my 401k that I could take out and pay it off with. The home is worth about 55-60k right now.

I was thinking of getting a principal residence loan from my 401k and repaying it. I'd have a better return on the house that I'd ever get out of my 401k.

I'm not sure we really want to live in it. How would the IRS prove or disprove that we're using it as a primary residence? What would be the implications if we didn't or decided not to?

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You really need someone who can give you local tax advice. This goes further than whether Uncle Sam knows you live in the house.

Also, be careful with loaning against 401(k)s. For one thing, in most cases, they're due if you ever leave the company (even if leaving is not by your choice). And, though some plans differ, you ordinarily are giving up the interest you could have earned on the money that's now not there. You actually may already know this, but other people thinking this may be a good idea should have all the info.

I'm curious as to how you can be sure that the financial return on this house will be better than anything you'd "ever" get out of your 401(k)?? Dunno about your 401(k), but mine will let me get as speculative as I can handle. Especially given the current real-estate correction, I find it a little hard to believe that a long-term investment in equities doesn't offer a better track record than home ownership.

    Bookmark   February 21, 2007 at 4:16PM
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For me paying off a 14k loan with a total 18k investment on a property worth 55-60k is a pretty good return. I know I can't possibly make 40 k on my 401k in the next few years. Real estate in my market is appreciating because of a casino put in a few miles away. Lots of jobs, lots of people that need jobs. Lots of demand for starter homes. We've been renting it out and getting 325 a month which is very low rent around here. We've been very lucky with our renter. I'm not sure how much I like being a landlord though.

    Bookmark   February 21, 2007 at 4:35PM
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Since you already own the home and rent it ... it is a rental (not a 2nd home and not a vacation home) ... and the IRS looks at it as a rental investment property.

You should be filing a Schedule E showing your rental income, expenses (such as mortgage interest and real estate taxes), and depreciation. You may have a yearly profit or a loss on the rental. Based on the information you provided you will have a taxable gain on the rental investment property when you sell it.

It would be a hard sell to the IRS to claim it as a 2nd home or vacation home since it's right next to your principal residence. And if the IRS looks into it I'm sure the papertrail (utility bills, your renter files tax returns etc using the address) will clearly show it is a rental.

    Bookmark   February 21, 2007 at 5:03PM
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The problem is that we have this balloon payment due in June or we won't own it anymore :~) I can still take it out of my 401k at a higher interest rate. Regardless the money and interest would be going back to me instead of a bank, which is nice.

We don't "have" to rent it. We didn't until December. It sat there as our guesthouse until then. The problem was we never had any guests in it. It has been like my life size doll house. It is fully furnished and decorated. We had slumber parties and regular gatherings over there instead of our "regular" house. It is filled completely with all of our stuff and we do spend time there when there isn't a renter in it.

    Bookmark   February 21, 2007 at 6:00PM
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"...We don't "have" to rent it. We didn't until December..."

Regardless of if you "have" to or not, as of December it became a rental property. You really need to talk to your tax preparer to learn more about rental properties.

As for the "401K principal residence loan" check with your 401K plan administrator to see if it will qualify as deductible mortgage interest. If not then I would consider getting a home equity loan since the amount you need is minimal. Home equity loan rates are pretty good, you can select the length of the loan, closing costs are minimal, and you know for sure that the mortgage interest is deductible.

Is there a specific reason that you want to take the loan from your 401K rather than getting a home equity loan?

    Bookmark   February 21, 2007 at 11:31PM
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I don't want a loan on this house if I can avoid it. I want it to be free and clear. Our regular home was purchased three years ago and we're at the 80% that our bank will lend us on it because of a recent major remodel/addition.

    Bookmark   February 22, 2007 at 5:45AM
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You want advice on a fraudulent loan?

    Bookmark   February 22, 2007 at 2:32PM
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Well it's not exactly fraudulent as we use the property as much as we use this one. I'm not talking about a house in another state or another town or even on another block. We would have combined the properties if there wasn't a messy little easement between them. We rented it over the winter as there was a boy who was kicked out of the Amish church and had nowhere to go. He plans on moving to another state next month.

This is our guest house. We do spend time there but we don't sleep there. The question wasn't how to make a fraudelent loan. The question is it really fradulent? I can get the money out of my 401k easier if it's not a home loan.

    Bookmark   February 22, 2007 at 6:40PM
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I really do not see what the whole obsession of having the home "free and clear". If you have to carry a loan anyway what difference does it make where the loan comes from? At least if the loan is attached to the property you should be able to deduct some if not all the interest for tax purposes.

Since you do not "have" to rent it get the smallest loan you need and apply all the rent recieved directly towards the home equity loan and pay it off that much faster. The other option is take out a HELOC instead so that you always have access to the equity (unless the bank reviews your situation and changes the credit line) as you pay it back so you have a back up emergency credit line (and since you have already said you want it "free and clear" there should be no risk of not paying off the line more than tapping into it).

    Bookmark   February 24, 2007 at 4:39AM
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blue_velvet-elvis, I don't understand why you seem to be asking for advice but have no interest in taking it. Why ask?

knhav gave you very good advise "... If you have to carry a loan anyway what difference does it make where the loan comes from? At least if the loan is attached to the property you should be able to deduct some if not all the interest for tax purposes...". Taking a home equity loan would be better than taking money out of your 401K. You can claim the home equity interest against your taxes LEGALLY. The home equity loan can be taken against the equity in the 2nd home.

And no matter how much you try to rationalize it ("dollhouse", "guest house", "messy little easement") the home was rented and the IRS will consider it a rental investment property! You can claim the rental income, rental expenses, and depreciation. You will likely have a rental LOSS to show on your income!

Since the property is on a seperate deed from your main home it will be considered investment property when you sell it and taxed for capital gains. An exclusion for the sale of a home is only for your MAIN residence and can not be claimed on the house next door that you also own.

If you talk to your tax preparer I'm sure they will give the same advice. If you don't have a tax preparer then I would really advise that consider getting one!

    Bookmark   February 25, 2007 at 7:18PM
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A house is either your principal residence, second home or investment rental. Which one is it? You can call it second home, but it is not your primary residence for loan purposes, as mentioned it is fraud to call it that. Sounds like, looks like rental investment since you've already rented it.

    Bookmark   February 25, 2007 at 7:27PM
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Not to be too nit-picky - but if you don't live in the house, sleep in the house, and if you use it as a guest cottage, plus rent it out, then it is NOT your principal residence. So a loan from your 401K account declaring it is, and subsequently reporting to the IRS that it is your prinicpal residence, is, by definition, fraudulent.

The IRS sees black and white. Pesky little easements will come back and bite you in the behind.

I do, however, sympathize with your plight. Your solution is to get the properties legally joined. How this could be done would be up to your local jurisdiction, and could be complicated and expensive. It is possible, however, to have properties re-zoned, or to join separate but adjoining lots.

Personally, I think it would be more trouble than it's worth, and would then prevent you from selling off one property by itself. You would have to go through the whole legal process of "unjoining" the two lots.

So - will the IRS come looking for you? Maybe, maybe not. But if you have previously declared the home you live in now as a principal residence, the IRS will want proof you sold the residence, or converted it to some other use.

Personally I wouldn't want to take the risk. I would also view it as a cheat.


    Bookmark   February 25, 2007 at 9:24PM
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As it turns out it doesn't much matter. Same interest rate either way.
The renter whos been there for two of the 20 months that we've owned is moving away. It will be our guest house again.

We're always at a loss as to what to call the cottage. It's not really a rental. It just happened that a friend had his cousin need a place to stay immediately and knew we had an furnished house. People think us odd for not renting it out, however it's a nice little getaway. I also have my cottage garden there. For my DH it's more of a big storage unit. He has the second bedroom crammed full of "stuff".
For both of us, however, it's a safety net. We always thought if we both lost our jobs for whatever reason we'd have a paid off place we could either live in and not worry about losing a roof over our heads or pay off the mortgage on the other home so we wouldn't have to worry about having a roof over our heads.

I guess if I thought of it as something other than an addition to our house separated by a yard the decision would have been easy. I view it the same way as the garage and garden shed that are on the same property.

    Bookmark   February 27, 2007 at 7:54AM
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"I view it the same way as the garage and garden shed that are on the same property."

You can view it however you wish! But it is not your principal residence...

    Bookmark   February 27, 2007 at 8:54AM
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As I said it's not an issue as far as the 401k loan is concerned. The interest rate is the same. So, apparently I can view however I wish :~)

    Bookmark   February 27, 2007 at 11:24AM
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ummmm.... yeah... that's what I said!

    Bookmark   February 27, 2007 at 12:08PM
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So you've got everybody going around in circles because you have an idea fixed in your head and you only want to hear what you think the answer should be. But what the heck, if you want to take the risk who are we to gainsay you?

The IRS requires a primary residence be defined as living and owning 2 years out of the last 5 yrs, to the exact day, at that address. Proof is defined as a clear paper trail, involving drivers licenses, utility bills, and any other "formal" documents.

A link I found gives this answer in more detail, and I excerpted part of it, below:
Articles by Ilyce: What Makes Your Home A Primary Residence
REM #F663
By Ilyce R. Glink

Summary: A reader has purchased a home for their future retirement. They would like to designate their new home as their primary residence. Ilyce explains what the IRS will look at to determine what home is the primary residence.

Q: We just purchased a house for future retirement use and declared it not a primary residence during the transaction. We would like to know how we can change it to the primary residence while still keeping our current residence. Thanks.

A: You can only have one primary residence at a time. Simply declaring to the world that your new home is actually your primary residence isnÂt quite enough. You actually have to live there for a majority of each year.

If you're ever audited, the IRS will look up your phone records, bills paid, whether you voted in that district, and other things that would indicate how much time you spent in the new home. You would also have to file your income taxes listing the new home as your primary residence.

When you're ready to retire to this property, that's the time you should make it your primary residence. That way, you protect your ability to take the IRS capital gains exclusion for your current property, which amounts to taking the first $250,000 in profits tax-free (up to $500,000 if you're married). But you only get this as long as you've lived in the house for 2 of the last 5 years, and haven't used the exclusion in the past 24 months.

Here is a link that might be useful: Determining a Primary Residence

    Bookmark   February 27, 2007 at 9:12PM
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Reading through this thread I am amazed that so many people took the time to offer explanations and advice to the original poster. It's a wonderful resource to be able to come here for advice.

But I think it's time to end this thread as the original poster is obviously not interested in taking the advice that has been repeatedly offered by many posters. I think we all have to agree that at times you have to let go and let someone follow their own path regardless of what you see ahead.

    Bookmark   February 27, 2007 at 11:24PM
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L2L I DID take the advise and was not going to consider it a primary residence. It happened that the interest rate was the same. I still feel like it's an extension of our home, however, because of it's typical usage and the proximity.

However, if my 401k takes a few more nose dives like yesterday it's a moot point.

    Bookmark   February 28, 2007 at 2:57PM
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