How a Cash Out Refinance Affects Income Tax Filing

A cash out refinance is a source of income to you and your home. You may not think of it this way because you know you will have to pay the money back. The IRS knows the same thing, so you will not be charged taxes on the income during the time the loan is alive in most cases. However, it is important to declare the refinance to the IRS when you file your taxes to ensure you do not have outstanding obligations under a few particular circumstances.

Tax Implications of Forgiven Debt

Any time you refinance, there is a chance you are settling a portion of your previous debt obligation. This is not typically the case with a cash out option, which actually converts your equity to debt, increasing your debt load over time. However, you may be reducing your total loan obligation at the same time you cash out. For example, if your previous mortgage balance was $240,000 and you had $60,000 of equity in the home, you may take a $270,000 loan when you cash out. It is possible you only pocket $30,000 and pay the remaining $240,000 to the initial lender. If you negotiated a lower one-time sum payment, though, of $220,000 and pocketed $50,000 while maintaining $60,000 in equity, you actually generated $20,000 of profit by converting debt to income. In this case, the $20,000 of forgiven debt you received from your lender may be considered income and be taxed as such.

Tax Implications of Unpaid Debt

You will need to repay the entire new refinanced mortgage in order to be excused of obligation to pay taxes on the sum. If you do so, then the loan was never actually converted into income. Instead, you actually paid interest on the loan, and it ended up costing you more money than you actually initially received. Whenever you do not pay back a debt, the sum can be counted as income. This typically occurs only in unique foreclosure situations where the lender sells the property and does not fully recover on the mortgage. The lender would seek to recover the difference between the property value and mortgage balance from you in order to relieve you of obligation to pay the loan. If the lender forgives you of this sum, you will owe taxes on the difference.

Tax Implications of Cashing Out

In general, there are no tax penalties for cashing out of a mortgage if you cash out into debt. However, if you cash out into equity, then you may owe a sum. This usually means you have sold the property, in which case all of your sales profit would be taxable. It could also mean you sold part of the property, though, such as an adjacent lot or one of two units in a town home. If you do this and pay off the mortgage, the remaining sum you received as profit is taxable. Cashing out on a mortgage by prepaying with your own money can also generate tax implications if you negotiated a partial mortgage payment instead of paying in full.

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