Enhanced IRA tax break for some home buyers

One of the nice tax breaks for folks looking to buy their first home is the ability to use IRA money for the purchase without paying a penalty for early withdrawal.

Usually, when you take an early retirement account distribution (that is, withdraw money before you turn 59½), you have to pay a 10 percent penalty along with the tax due on the withdrawn funds. But if you use the cash to help buy your first home, although you still have to pay the taxes on the withdrawal, you don’t face the penalty.

It’s not an ideal way to come up with a down payment. You’re literally robbing your retirement. But the hope is that your home will appreciate enough over the years to eventually let you get back the IRA earnings you lost.

Plus, you get a home of your own.

A lot of folks take advantage of this penalty-free IRA withdrawal option to buy their initial residence. And that practice might increase now that the subprime mortgage market has tightened its credit standards.

With a lot of the more insane "creative" mortgage options are being ditched — Mortgage Matters blogger Holden Lewis just wrote about the demise of the 2/28 mortgage — tapping IRAs might be one of the few options for would-be home buyers who have no or very little in other savings.

But these folks also might face other home buying complications. Even in ideal cases, home purchases sometimes fall through. What happens if you’ve taken out IRA money for a house, avoided the tax penalty and then didn’t end up buying the residence after all?

Extended rollover period: It seems the IRS has a bit of compassion for these folks.

In a private letter ruling, the IRS has allowed a taxpayer 120 days to roll the money back into her IRA. That’s twice the standard 60-day period allowed to return an IRA distribution.

By now being able to redeposit the IRA money, the taxpayer avoids the penalty and due taxes.

She won’t be able, though, to use the money again if she finds another home relatively quickly. Putting the IRA money back is considered a rollover and tax law says you only get one tax-free rollover from an IRA every 12 months.

In issuing private rulings, the IRS is always careful to note that "This letter is directed only to the taxpayer who requested it" and that the Tax Code "provides that it may not be used or cited as a precedent."

Such rulings, however, are typically viewed as a good way to get an idea of the IRS’ thinking in particular tax areas.

First home flexibility: An interesting thing about the first-home, early IRA distribution exception is the IRS’ definition of a first home, or rather a first-time buyer.

You can use your IRA money without penalty if you’re a "first-time home buyer," a standard that is met, according to IRS Publication 590, " … if you had no present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to by, build or rebuild."

So it doesn’t have to technically be your very first ever home. You just need to be a first-time home buyer in the IRS’ eyes.

And couples take note. If you’re married, your husband or wife must also meet the first-time buyer non-ownership requirements.