A homeowner with enough equity in his home still may qualify for cash-out refinancing to pay for home improvements or other things he may want to purchase. These cash-outs sometimes involve significant sums, which can draw the atttention of the IRS, potentially affecting the homeowner in various ways.
The House Cash Machine
If a homeowner decides to refinance his home to take advantage of the equity, the cash that he receives from the refinance is not taxable income, according to the IRS article "Home Foreclosure and Debt Cancellation." The borrower must pay the loan back--the loan is not income, so income tax is not due. The borrower may borrow more than his existing loan balance and take that amount as cash provided he has sufficient equity in his home to secure the loan.
If the equity in a taxpayer's home has increased, on paper he has experienced a capital gain. This means that he can refinance to take advantage of that appreciation without paying taxes. If he were to sell his home, he may have to pay capital gains taxes on the amount of appreciation. If the home is his primary residence, a significant portion of the gain may be exempt from capital gains taxes. As of 2010, a homeowner can exempt $250,000 in gains over his lifetime, or $500,000 if he files his income taxes jointly.
Foreclosure and Short Sale
In a foreclosure or short sale, the homeowner may owe more that the home is worth, resulting in negative equity. In exchange for the homeowner assisting in the sale of the home, the lender may choose to accept the price the home brings as settlement in full of the mortgage, and forgive the balance. The lender will send a form 1099 to the borrower reporting the forgiven debt as income. Through 2012, this balance is not taxable if the short sale occurred on a primary residence with under $1 million in debt, unless the homeowner used the proceeds of the cash out refinance for something other than home improvements. If so, the amount of forgiven debt from the cash out refinance is taxable income.
While cash-out refinancing may provide a low cost, tax-free borrowing option for homeowners with sufficient equity, and provide a way for homeowners to borrow money and pay tax-deductible interest, it may not be the best way to finance purchases. Increasing the amount of mortgage debt on a home increases the borrower's risk of default in the event of a financial setback. A homeowner is better off not being able to pay a credit card bill than the primary mortgage.