What Costs can be Covered Under a Hardship Distribution for Purchase of a Primary Residence?

DWC | 10/30/18

QOTW - 10.30.2018 - What Costs can be Covered Under a Hardship Distribution for Purchase of a Primary Residence - Plan Distributions

Facts

One of the participants in our 401(k) plan submitted a request for a hardship distribution for the purchase of a primary residence.  On review of the supporting documentation, we discovered that the purchase has already occurred and that the requested distribution is to cover the cost of renovations prior to moving in.

Question

How strictly does the IRS interpret what costs qualify as being associated with the purchase of a primary residence?  Is there any wiggle room that would allow renovation costs to qualify for a hardship withdrawal for purchase of a primary residence?

Answer

The rules are fairly strict here.  In order to qualify for a hardship distribution, the amount requested must be necessary to cover costs directly related to the purchase itself and not improvements to the home after purchase.  However, there are some nuances to consider:

  • While the hardship withdrawal must be directly related to the purchase, it is not restricted to the purchase price and can include other items that are directly tied to the transaction, such as closing costs.
  • The amount of the hardship distribution can be grossed up to cover the anticipated tax liability associated with the withdrawal.
  • The purchase of a piece of land with the intent to then build a primary residence could qualify for a hardship as long as construction will begin contemporaneously with the land purchase. In other words, a participant could not take a hardship distribution to buy a piece of land now that will be used to build a primary residence years in the future.  There is no clear-cut answer as to how soon construction must begin, but it should be soon enough so that it acts as if it is all part of the same transaction.
  • The IRS has indicated informally that if only the participant’s spouse and children will live in the home but the participant will not, the purchase does not qualify for a hardship. However, in the event of a divorce, if the participant is buying out his or her ex-spouse from a jointly-owned home, that buy-out would qualify as a purchase of a primary residence.

We came across an interesting twist on this theme a few years ago.  A participant was renting a home, the landlord was way behind on mortgage payments, and the bank was about to foreclose on the house and evict the participant in the process.  The participant requested a hardship distribution to make the landlord’s mortgage payments in order to prevent eviction; however, since it was the landlord and not the participant who had the financial need, the request was denied.  When the participant decided to purchase the home from the landlord before the bank could foreclose, the participant was able to take the hardship distribution for the purchase of his primary residence.

Although many hardship distributions are straight-forward, many can be extremely subjective, and there are plenty of gray areas.  While it can be tempting to push the limits in order to help out a participant in dire financial straits, keep in mind that pushing too far can, at worst, jeopardize the entire plan for all of the participants.  At a minimum, correcting the errant hardship distribution can prove quite costly to all involved.

For more information on hardships and distributions in general, please visit our Knowledge Center here.

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Topics: Question of the Week, Plan Distributions, Hardship Distributions

The views expressed in this blog are those of the authors and do not necessarily represent the views of any other person or organization. All content is provided for informational purposes only and is not intended to be tax or legal advice.