If you were a homeowner who did a cash out refinance or home equity loan on your house and spent the money on things other than repairing your home, before it went to foreclosure, you may owe a big tax bill.
The IRS is looking into the foreclosures and short sales of those who refinanced their homes and then went into foreclosure, according to CNN Money:
Many homeowners took cash out when they refinanced their homes and used the extra dough to pay for new cars, boats or vacations. Say you did that and then got into trouble, losing the house through a foreclosure or short sale. Even if your lender waived the remaining debt, the IRS will treat as income the portion of the forgiven debt that you took out as cash and spent. Only the funds used to actually improve your home won’t be taxed. Yes, even if you spent the money on paying off your student loans or credit cards.
The IRS’ reasoning is that only the money spent on home improvement actually added to your home’s value. And that, presumably, diminished the difference between what you owed on your mortgage and the value of your home when it was foreclosed. via CNN Money