This continues to elude me

[Rich Hupper]

Hi Bp 

I have been an independent contractor for most of my life.  I am trying to understand exactly what a typical bank looks for when I apply for a residential mortgage. What number on my tax return will they use to calculate my maximum monthly payment?

Thank you

[Andrew Postell]

@Rich Hupper below is some information on how lenders use your tax returns to qualify you.  There are a lot of misconceptions on how banks lend because banks have "overlays".  Overlays are extra rules that banks put on loans to lend less money (aka being conservative).  For example, many banks require 2 years of tax returns.  But you only need 1 year of tax returns for a conventional loan in most circumstances but many banks choose to put an extra requirement to ask for 2 since it will limit their risk.  It can certainly get confusion.  And I think the information below might be a little overload so feel free to ask more questions if needed.  I tagged @Jeff B. in case some of this information is helpful. 

For a Conventional/FHA/VA Loan, taxes play a large role in calculating the income of an investor. One challenge that investors often face is our taxable income. Sometimes our taxable income can be $0 – and that's kind of the point of being an investor! Portfolio loans do not weigh tax returns as heavily as a conventional loan but portfolio loans also carry a higher rate, or they might have a balloon payment, etc. If we want to best, most favorable long term loan that we can find we should try our best to qualify for a conventional loan first. But there are some very specific strategies in using your tax returns to your advantage to help better qualify for a loan. Here's what I mean:

If you are using a Schedule C in your personal tax returns there are 4 important items to be aware of when a bank calculates your income.

Schedule C

Depreciation (Line 13/14) – can be added BACK as income

Business Use of Home (Line 30) – can be added BACK as income

Vehicle Miles (Line 44A) – can be added BACK as income

Un-allowed Meals and Entertainment (Line 24B) – is subtracted FROM your income

So if your Schedule C taxable income is $0 (line 31) but your depreciation is $10,000 then your actual income is $10,000! Your deductions can actually help you in getting qualified!

Those 4 areas may not sound like rocket science but attached to this post is an example......of an individual’s tax returns. On their tax returns they had Line 44A blank, so essentially $0…but then later on they listed vehicle miles in a separate line item. So the tax advantage by listing it in one section as opposed to another here is the same but now the method by which you qualify for a loan is at risk. Your loan officer has to go and convince an underwriter to use your business mileage if it’s not in Line 44A. Frankly, it’s an easy argument. That is, if your loan officer was good enough to detect it. The person’s tax return example here was a 300 page document. Why even risk someone not finding it or the argument made to the underwriter not being heard? Just enter it in the section 44A and you will be safe and making your deductions work FOR you!

Ready for some more? Here’s Schedule E:

Schedule E

Depreciation (Line 18) – can be added BACK

Casualty Loss/Amortization/One-Time Expenses/HOA Dues (line 19) – can be added BACK

Insurance (line 9) – Added Back

Mortgage Interest (Line 12) – Added Back

Taxes (Line 16) – Added Back

And this is why owning property is such a great method of building wealth. Nearly all of your normal expenses on a property can be deducted from your TAXABLE income but added BACK to your qualifying income for a conventional loan!

BUT THERE IS A REALLY IMPORTANT TRAP TO SEE WITH SCHEDULE E: your Schedule E returns have a line item of "Cleaning and Maintenance" (line 7), "Repairs" (line 14), and "Other" (line 19). This is where it becomes really important to work with a CPA that understands investment properties. Because if you just rehabed your property, is that a "One-Time Expense", "Repair", "Other" or partly "Cleaning and Maintenance" since you had to clean everything? What about replacing the roof? What about if your tenant moved out and you have to do some work because they trashed the property? If your tax professional doesn't know these rules get these to him/her asap!

Ready for some others? How about a S-Corp?

S-Corp

W2 income – that’s easy, you probably understood that your W2 income can be added BACK

K-1 income (box 1 & 2) – also pretty self-explanatory, but just in case, it’s added BACK

Amortization/Casualty Loss – Added BACK

Depreciation 1120s (line 14 & 15) – Added Back

However….

Mortgage Notes, bonds payable in less than 1 year (Schedule L, line 17)- this is SUBTRACTED from your income

Meals & Entertainment (Schedule M1, Line 3b) – SUBTRACTED from your income

Non re-occurring Other Income (1120s line 5) – SUBTRACTED from your income

Partnerships

W2, K1 (box 1,2, & 4), Depreciation, Amortization/Casualty Loss – all added BACK

Non re-occurring Other Income, Meals and Entertainment, Mortgage Notes payable in less than 1 year, AND Ordinary income from Other (1065 line 4) – all SUBTRACTED from your income

I certainly hope that some of what is contained here helps your understanding of what goes on behind the vail of underwriting. If you have questions about these items please feel free to ask.  If you think this was a good post please vote for it.  Thanks!