IRA home purchase closing credits

[Starrynights11]

I have taken out funds for the purchase of a first home. The sellers are now providing credits as closing for repairs. My current expenses (closing total plus appraisal and inspections) are currently $9,000. If I receive $4000 closing credit for repairs am I now only able to use $5000 penalty free or can I still use all $9000 since the $4000 is a concession for repairs unable to be done before close? 

[Opus 17]

If you are only paying $5000 of your own cash to close on this house, then only $5000 of the IRA withdrawal is eligible for the penalty exception.

If you have already withdrawn the $10,000, you have 120 days to pay it back without penalty. (The normal period of time to repay a distribution is 60 days, so you will have to advise the plan trustee that this was for a home purchase and that the 120 day rule applies.)

Remember that distributions from an IRA are always subject to regular income tax. The only thing we are talking about here is the 10% additional tax penalty for early withdrawal.

[Starrynights11]

Thanks for your response! So, I am just out the repair credit then? If the repair had been able to be made before purchase I wouldn’t have received this credit. If I now return via rollover $5000 to avoid a penalty, I am now left with no money to make the repair? I guess, this is where my confusion stems. 

[Opus 17 · Accepted solution]

Unfortunately, the law doesn’t have your particular situation in mind.  A sellers concession is treated as a reduction in the sales price, and it doesn’t really matter what the reason is.

You must use the IRA proceeds to pay for “qualified acquisition costs”. Qualified acquisition costs are costs used to buy, build, or substantially improve your home, plus any usual settlement fees associated with the transaction.  For example, if you were paying for an attorney or a survey or inspections out of pocket that is not going to be part of the $5000 you pay at the bank closing, you can include those costs as part of your “qualified acquisition costs.”

You may also be able to invoke the “substantial improvement“ part of the definition of acquisition costs depending on what the repair is.  There are three elements here. First is the definition of an improvement. An “improvement“ is a permanent upgrade to the property that adds value or extends the working life of the property or one of its systems.  For example, a new roof would be an improvement because it extends the working life of the roof.  So would a new electrical system or tearing out recalled plastic plumbing.  Repairs maintain the property in as-is condition and are not improvements. This would include cleaning and painting.  

The second element is whether an improvement is “substantial“.  There is no particular IRS guidance on what constitutes a substantial improvement.  If audited, you would have to explain to the auditor’s satisfaction.

The third element is that to be eligible for the penalty exemption, you must pay for the substantial improvement within 120 days of the date that you withdrew the money from the IRA.

So, if you believe that the work that needs to be done constitutes a substantial improvement, and if you can complete it within 120 days of the date you withdrew the money from the IRA, you can use the IRA money for the improvement and still be exempt from the penalty.  In TurboTax, when you enter the 1099 – R for the IRA withdrawal, you will only be asked to certify that you meet the exemption. You do not send proof with your tax return, but you should keep the proof on hand for at least seven years in case of audit.

If the work that needs to be done would not be considered a substantial improvement, you could still withdraw money from your IRA to pay for it, you will just have to pay the 10% penalty tax along with regular income tax.

You are never “out” the repair credit, it still is a price reduction on the cost of the house. The issue is whether or not you qualify for this particular tax exemption when you pay for the repairs.

[Starrynights11]

Thanks! I think we may end up ok. The credit is for a replacement hvac - 40 yrs old. Seems it could be argued to be a substantial improvement. 

[dmertz]

The rollover deadline is extended from 60 days to 120 days only if the closing is delayed beyond the 120 deadline to apply the funds to the home purchase or the purchase is cancelled (§ 72(t)(8)(E) "Special rule where delay in acquisition").  It appears that neither of these situations occurred, so the rollover deadline remains the 60th day following the date the distribution is received and the distribution remains subject to the one-rollover-12-months rule.

[Starrynights11]

Thanks to you both! I have looked for the substantial improvement language and can not find it in regards to using an IRA. I wonder if rebuilding has replaced it. We would have no problem using the funds within 60 days of withdrawal. Of course, I’d prefer not to make the repair with money that requires a 10% penalty. 

[dmertz]

You are correct, the language is in the statute allows the money to be spent "reconstructing" a first home, nothing about "substantially improving" a first home.  I can't see how replacing the HVAC qualifies as reconstructing the residence.  The exact wording in the statute is:  For purposes of this paragraph, the term "qualified acquisition costs" means the costs of acquiring, constructing, or reconstructing a residence.

[Opus 17]

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@Starrynights11 wrote:

Thanks to you both! I have looked for the substantial improvement language and can not find it in regards to using an IRA. I wonder if rebuilding has replaced it. We would have no problem using the funds within 60 days of withdrawal. Of course, I’d prefer not to make the repair with money that requires a 10% penalty. 

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You are looking for IRC §72(t)(2)(F) and 72(t)(8). Section 72(t)(2)(F) is the penalty exemption for first time home buyers and section 72(t)(8) is the definition of a first time homebuyer.

For purposes of this paragraph, the term “qualified acquisition costs” means the costs of acquiring, constructing, or reconstructing a residence. Such term includes any usual or reasonable settlement, financing, or other closing costs.

This is a bit odd because in other places, "qualified acquisition cost" for a primary residence is defined as "buy, build or make substantial improvement to", such as section 163 on mortgage interest.

I don't know why Congress used "reconstruct" in one law and "substantial improvement" in a different law. I would hope that an auditor would not make a big deal of it, but I am not an attorney. 

https://www.law.cornell.edu/uscode/text/26/72

[dmertz]

"I don't know why Congress used "reconstruct" in one law and "substantial improvement" in a different law."  But they did, presumably because this penalty exception is intended to apply only to first-time home purchases, and the IRS must go by what is written in the applicable section of the law.  The substantial-improvement definition allows for deducting interest on loans used to pay for such improvements made later, provided that they are secured by the residence, entirely different circumstances from a first-home purchase.