Tax Fact 6-Cancelled Debt From a Refinance Can Be Taxable Income

15 Mar Tax Fact 6-Cancelled Debt From a Refinance Can Be Taxable Income

In explaining tax on mortgage debt forgiveness, the IRS stresses, as tax fact number 6, that proceeds of refinance debt used for purposes, other than buying, building, or making a substantial improvement in the principle residence, do not qualify for exclusion from income if the debt is cancelled. This can be important. Many lenders require home owners to payoff outstanding credit card debt when they refinance their home. This made sense to the lender, in that it would be easier for the homeowner to make the required house payments if they did not have to pay other debt. However, money used to payoff credit card debts is not “qualified” for exclusion from income under the Mortgage Forgiveness Debt Relief Act of 2007.

Also it should be noted that funds from a refinance used to pay college tuition do not qualify for the exclusion. Many parents borrowed against their homes to fund college education for their children. Despite the noble intent, Congress did not see fit to exclude debt incurred for this purpose from inclusion as taxable income if the debt is cancelled. This does not mean you have to pay tax if you borrowed money against your home to pay for a college education. However, if your home is foreclosed and the value of your home at the time of foreclosure is less than the amount of the debt, and a portion of that debt was used for a purpose other than buying, building or substantially improving your home, the amount cancelled may be taxed as income.

This series of articles focus on the Mortgage Forgiveness Debt Relief Act of 2007 and how it may avoid a tax liability. In addition to this statutory exclusion from income for tax purposes, there are other exclusions that could apply. For example, bankruptcy discharge or insolvency at the time the debt was cancelled could exclude some or all of the debt that has been cancelled from income for tax purposes.

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I was admitted to practice in 1978. I am certified as a Consumer Bankruptcy Specialist by the American Board of Certification. I regularly speak on tax and bankruptcy issues at state, regional and national conferences. Years of experience in practice before the Internal Revenue Service and Oregon Department of Revenue have given me the background to resolve a large variety of consumer tax issues.
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