Tom Kelly: First-time homebuyers should try everything else before tapping IRA

The question continues to haunt homebuyers: With prices rising in so many neighborhoods, how do young people afford to get in the door?

For example, a “near retired” couple recently sent an email, asking if they could use their IRAs to help a grandchild purchase her first home. While consumers typically try to keep individual retirement accounts geared to serve only retirement plans, terrific intentions sometimes have taken an alternate road.

A provision in the 1997 Taxpayer Relief Act allows penalty-free withdrawals of up to $10,000 for the down payment and closing costs of a first home. “First” applies if you or your spouse haven’t owned a principal residence at any time during the past two years. Withdrawals can be made from established IRAs of spouses, parents, children, grandchildren or ancestors without penalty as long as they total no more than $10,000.

Lawmakers said this move would help “tens of thousands” of Americans overcome the single-biggest barrier to homeownership – the lack of sufficient cash for closing.

But professional accountants say it’s wise to leave an IRA alone, and only use it as a last resort for buying a home. If you can borrow the money for the house from Uncle Joe or a good friend, it would probably be the better way to go.

That’s because tax people know that owning a home is also a “forced savings plan.” The money that you put into homeownership is usually returned – with appreciation – when it’s time to sell. Often, the appreciation can offset the amount of interest the borrower has paid on the home loan.

There’s a reason for the R in IRA. If the account were to be used during our working years, the R would have been substituted for a W. Given rising home prices and stringent loan guidelines, I expect lenders again to sharpen their pencils in an effort to corral both IRA and home-loan customers. The competition for consumer dollars is intense, and those lenders who can produce a workable, creative niche often soar above their rivals.

More than 15 years ago, a veteran mortgage broker dreamed up an IRA-based home-loan program. Changes to an affordable-housing bill were not signed, however, and the program, which featured loans at a full percentage point below market rates, never got off the ground.

The problems arrived when the fine-print IRA rules were scrutinized. Bankers, the creative broker found out, were not supposed to give consumers anything of value to attract customers.

The basic idea was similar to several “pledged asset loans” that are on the market today. The concept is to keep an asset intact while using it as collateral for a loan. For example, brokerage houses allow some clients to “margin,” or borrow against, certain stocks.

Misinformation given by local Internal Revenue Service offices has added to the confusion. According to a recent federal tax-court case, a couple were charged for withdrawing their IRAs to buy a home even though their local IRS public-assistance representative said the funds would not be taxable.

Emma and James Clarke each withdrew $16,000 from their traditional IRAs. They wanted to be certain the amounts were not taxable because the Clarkes said they would not be able to purchase the house and pay taxes on the $32,000 withdrawal. According to the Clarkes, they were told no penalty would be assessed. Yet traditional IRA funds are distributed as ordinary income and thereby taxable. (Roth IRA funds are tax-free.) The court ruled that when IRS employees give incorrect interpretations of the law, the IRS is not bound by that advice.

If you are able to borrow the down payment for a home from Uncle Joe, ask if he can do so outside of his IRA. Perhaps he’s got a ton of Costco stock he can margin. Or, maybe your boss will come through with that no-interest loan she’s been talking about for years. Do your best to keep the R in Individual Retirement Account.