How Tax Returns Affect Real Estate Investor Bank Financing

15 Replies

I don’t see a clear answer to this on the forums.  I keep having bankers say “be careful with reporting losses on your taxes because it could make you unbankable.”  What does this mean?  How do you make sure that you don’t make yourself unbankable especially if you have a ton of write offs.

You're not allowed to file a false tax return. 

That means it's as wrong to purposely leave off expenses so you seem more profitable....as it is to just make up more income to look more profitable. or to make up more expenses so you pay less tax. 


You can be strategic with your tax professional, plan out when renovations are done, discuss upcoming rental purchases ect so that you can put some thought into which year bigger expenses report on. 

The big ticket item on many tax returns is depreciation- and lenders add that back on rentals when it comes to determining lending. 

@Natalie Kolodij , The statements, "You're not allowed to file a false tax return.  That means it's as wrong to purposely leave off expenses so you seem more profitable ..." may well be true in your moral opinion (not in mine), but the law has no problem with leaving expenses off your tax return.   The tax code places burdens to report income and allows, but does not require the reporting of expenses.

@Johnoson Crutchfield ,  Banks need proof of income.  You are "unbankable" as in unable to get a loan if you have low income with which to repay the loan.   High real estate deductions for depreciation, interest and "maximized" expenses can make it look as though you have very little profit/income.  That would mean banks would not extend a loan to you because your financial statements indicate that you do not have the resources to repay a loan.

Originally posted by @Davido Davido :

@Natalie Kolodij, The statements, "You're not allowed to file a false tax return.  That means it's as wrong to purposely leave off expenses so you seem more profitable ..." may well be true in your moral opinion (not in mine), but the law has no problem with leaving expenses off your tax return.   The tax code places burdens to report income and allows, but does not require the reporting of expenses.

That's incorrect. And even if it wasn't- falsifying a tax return for the purposes of getting a  loan would be mortgage fraud. 

Literally as a big warning in IRS Pub 596 

"When figuring your net earnings from self-employment, you must claim all your allowable business
expenses."



https://www.irs.gov/pub/irs-pdf/p596.pdf



https://www.govinfo.gov/content/pkg/USCODE-2010-title26/pdf/USCODE-2010-title26-subtitleA-chap2-sec1402.pdf

 You can also view revenue ruling 56-407 on the topic too 

Originally posted by @Davido Davido :

@Johnoson Crutchfield ,  Banks need proof of income.  You are "unbankable" as in unable to get a loan if you have low income with which to repay the loan.   High real estate deductions for depreciation, interest and "maximized" expenses can make it look as though you have very little profit/income.  That would mean banks would not extend a loan to you because your financial statements indicate that you do not have the resources to repay a loan.

Depreciation does not come into your appearing to be able to pay back a loan- lenders add this expense back as they know it's not a cash out flow. 

 

IRS Requirements to report expenses are limited to specific circumstances, such as for those who claim Earned Income Credits.

CONCLUSIONS
(1) In cases where the taxpayer reports net earnings from self-employment
without claiming the applicable business expenses, the net earnings from
self-employment must be adjusted by those business expenses. The
taxpayer’s EIC and self-employment tax liability are both computed on the
adjusted net earnings from self-employment.

Originally posted by @Davido Davido :

IRS Requirements to report expenses are limited to specific circumstances, such as for those who claim Earned Income Credits.

CONCLUSIONS
(1) In cases where the taxpayer reports net earnings from self-employment
without claiming the applicable business expenses, the net earnings from
self-employment must be adjusted by those business expenses. The
taxpayer’s EIC and self-employment tax liability are both computed on the
adjusted net earnings from self-employment.

What is this from? 

I'm not going to sit on the internet and argue all day- but file a falsified return is not allowed, and using a falsified for loans is definitely illegal- so I'm not really sure why you're so dead set on trying to prove that you can. 

 

@Natali Morris , the idea that falsifying a return has been suggested in this post is incorrect.  Rather I attempted to point out (perhaps inarticulately) that I disagree with your explanation of what it means to file a false return.  If I am mistaken, then your input is of considerable value both to me and to the BP community.  Your statement was,

"That means it's as wrong to purposely leave off expenses so you seem more profitable."

You have correctly pointed out that in some specific instances, such as when a person claims the earned income credit, the IRS does state that reporting of expenses is required.  I promptly thanked you for that valuable correction and merely pointed out that the expense reporting requirement you cited is limited to instances where the tax payer is seeking the "Earned Income Credit".   The very publication that you quoted the requirement to report expenses from, is titled, Earned Income Credit (IRS Publication 596).  The Revenue Ruling you cited (56-407) explains that since the EIC formula requires the taxpayer's "net income", in those instances where the filer claims self employment income, the business expenses which are used to determine the filer's net income should be included in order to claim the credit.  My quote in a previous post regarding the IRS "Conclusions" is from Revenue Ruling 56-407 which is more fully cited next.


This Chief Counsel Advice responds to your memorandum requesting advice regarding the interplay between eligibility for the earned income credit under Internal Revenue Code (I.R.C.) § 32 and net earnings from self-employment under I.R.C. §1402. Chief Counsel Advice is not binding on Examination or Appeals and is not a final case determination. This document is not to be cited as precedent.

ISSUES
(1) How are a taxpayer’s Earned Income Credit (EIC) and self-employment tax liability computed in cases where the taxpayer reports net earnings from self employment on Schedule C without claiming the business expenses applicable to the Schedule C business?

.....
CONCLUSIONS
(1) In cases where the taxpayer reports net earnings from self-employment without claiming the applicable business expenses, the net earnings from self-employment must be adjusted by those business expenses. The taxpayer’s EIC and self-employment tax liability are both computed on the adjusted net earnings from self-employment.


So yes, the IRS is inclined to argue that tax payer's who want the EIC tax credit need to report their deductions.  The IRS position is that "net profit" is required to calculate the amount of the credit.  That is where I am in agreement with you.  Note that the IRS specifies the conclusion of its own chief counsel in this matter is not binding, not a final determination, and not to be cited as precedent.  Still, there is a likely requirement to report expenses when claiming the EIC.

That leaves the matter of whether a tax return generally becomes a false return if a filer does not report all, or even any of their legitimate business expenses.   My claim is that on federal tax returns in which the filer does not claim the Earned Income Credit, there is no requirement to report any business expenses.  The IRS code defines expenses as allowed, -not as required.  See, USC 26 section 1402 Definitions Part a. Net Earnings from Self Employment,

"The term 'net earnings from self-employment’’ means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business,.."


Surely you are aware that virtually no business owner even knows, much less records and reports, every expense.  Would you claim that all tax returns which miss an allowable expense are false?   Nothing that you've posted establishes that reporting of business expenses is generally required.  If expense reporting is not required, then filing a tax return without expenses or with incomplete expenses is not filing "a false return".  It is filing a permissible return.  If you are aware of any case, ever, in which the IRS prosecuted a filer for not reporting a Real Estate expense, then please do enlighten me and all the readers of BP.   Share it.

The situation is different when an investor submits financial statements for a loan application.  I agree that it would constitute fraud to submit a profit and loss statement which omitted expenses with the intent to make ones business appear more profitable.  However, a P & L is a different document from a federal tax return.  They have different purposes and do not need to reflect the same or even similar health of the business.  There is no fraud involved in supplying a true copy of one's federal tax return return -even if some or all expenses have been omitted.  The tax return must only meet the IRS requirements.  Which is likely the reason that lenders generally require profit and loss statements in addition to Tax Returns.

I'd be pleased to learn more (like your citation of the expense reporting requirements to claim the EIC), but as it stands your position that it is generally wrong to purposely leave expenses off a federal tax return so that the filer seems more profitable to a bank is not established by the IRS code.  And the idea that it is fraud to submit a true copy of ones federal tax return that intentionally and permissibly omitted expenses is not supported by the law. 


It has come up directly in pubs related to EIC because people can abuse it with regard to that credit. 

Not everything in tax law is cut and dry. 

The literal definition of "net earnings from self-employment" in the IRC which is the actual law that governs tax filings is " The gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to his trade or business". 

"Preparing and filing a false return" is one of the defined items of tax fraud. If you know you have those expenses and leave them off on purpose...guess what? That's a false return. 

And again- if you intend to use that return to obtain a loan leaving off expenses to show higher income is just as bad as literally making up extra income to a lender. It's an inaccurate tax return that you knowingly generated to make it look like you really earned more than you did to obtain a loan. 


You've sure spend a LOT of time today trying to prove why/ how you should knowingly report a return that doesn't clearly state the actual amount of money your business made for the purposes of obtaining a loan you really can't afford because you inflated your income.

Here's what I've literally seen people do: 

Leave off expenses to get a loan- then switch tax prepares to amend pretending they didn't know about those expenses so that now they pay less tax by amending to claim those expenses. It's so unethical, it's fraudulent on several levels- and if you want to be the person publicly advising others (who'se tax returns you're not responsible for in any way) to do it then that's fine. That's your reputation. 


https://www.biggerpockets.com/blog/2015/01/15/tax-write-off-affect-loan-approval/


Amanda Han who is pretty well known on BP literally wrote about this and being strategic and planning- notice her suggestion wasn't "don't report all your expenses". It was planning legally, and strategically. 

@Johnoson Crutchfield

Thanks everyone for the replies. It seems this post when a different direction that intended. Specifically, I want to make sure that I remain bankable and wanted to know if there is a way to know before filing a return if I will remain bankable? My bankers definitely don’t think it’s illegal to not report all expenses because it sounds to me like they want me to limit expenses and deductions to make sure income is high enough to qualify. Any ideas on how to find out what the threshold is?

@Johnoson Crutchfield , there are many comments that discuss limiting expenses and deductions to make sure income is high enough to qualify -in the Amanda Han article mentioned by @Natalie Kolodij .   That article appears to be right in the direction of your post.  Thank you for the link Natalie.  Amanda Han's article and the replies to it can be found here:  

https://www.biggerpockets.com/blog/2015-01-15-tax-write-off-affect-loan-approval

Neither the article nor the replies specify the threshold or Debt to Income ratio that they needed to get the loans they sought.   In any event, the threshold debt to income ratio is likely to be different from bank to bank, from residential loan type to commercial, and from month to month as lending requirements vary according to the economical cycle.  However, each bank should tell you how much income and what debt to income ratio they require for the type of loan you seek.

@Natalie Kolodij , for your benefit and for anyone else who reads this post, it is erroneous to suggest that I have been;

"...trying to prove why/ how you should knowingly report a return that doesn't clearly state the actual amount of money your business made for the purposes of obtaining a loan you really can't afford because you inflated your income."

Nothing in my posts state that is what I do, what I want to do, or what I recommend doing.  Instead, my claim is,

 "...the law has no problem with leaving expenses off your tax return."  

"My claim is that on federal tax returns in which the filer does not claim the Earned Income Credit, there is no requirement to report any business expenses. The IRS code defines expenses as allowed, -not as required."

It is also misleading, erroneous, and (in my view) unethical for you to attempt to impune my reputation by reciting a questionable tactic that I've neither mentioned nor hinted at and then attempt to connect that tactic to me as something I advise.  Your last post ends with the statement that you've seen people;

"Leave off expenses to get a loan- then switch tax prepares to amend pretending they didn't know about those expenses so that now they pay less tax by amending to claim those expenses. It's so unethical, it's fraudulent on several levels- and if you want to be the person publicly advising others (who'se tax returns you're not responsible for in any way) to do it then that's fine. That's your reputation."

Nothing in my posts mentions or suggests any such activity.   Within this thread, amending returns to later add back expenses is entirely your idea.  I believe it is dishonest to attribute a tactic only you have mentioned to another BP poster.

You were correct that there is a possible requirement to report expenses when a tax payer seeks to claim the Earned Income Tax credit.  My point was that claiming the EIC would be an exception to the general rule that reporting expenses is allowed, but not required.  

Of course you, or anyone, is entitled to personally believe; 

"That means it's as wrong to purposely leave off expenses so you seem more profitable."

"If you know you have those expenses and leave them off on purpose...guess what? That's a false return.  


And again- if you intend to use that return to obtain a loan leaving off expenses to show higher income is just as bad as literally making up extra income to a lender. It's an inaccurate tax return that you knowingly generated to make it look like you really earned more than you did to obtain a loan." 

However, such statements are not the law.  The IRS code defines deductions as "allowable", not as required, despite your personal view of how it should be.  I have no problem with your right to believe those statements.  Go ahead and state that for you, -leaving allowable expenses off a tax return form is wrong and for you such a return is "false" and or "inaccurate". And for you leaving expenses off a tax return is "just as bad as making up extra income to a lender."   I acknowledged your right to believe such things in my original post on this thread.

Th(os)e statements,  ..." may well be true in your moral opinion (not in mine), but the law has no problem with leaving expenses off your tax return. The tax code places burdens to report income and allows, but does not require the reporting of expenses.

Again, nothing I've written in this thread states that leaving expenses off a tax return is something that I recommend.  I personally believe that not including expenses is almost always disadvantageous.  Instead, the point of my posts is to clarify that the law (IRS Code) does not reflect your personal morality on this matter.  Still, prior to this specific post, nothing I'd written was intended to question your morality.  I pointed out that the IRS code is not a stringent as is your personal morality nor as stringent as your original post suggests the IRS Code might be.  No matter how you personally view a federal tax return that intentionally fails to report legitimate expenses, such returns are valid returns as a matter of law under the IRS code.

Further, when a tax return is requested by a lender, a valid return can be submitted without danger of it being mortgage fraud, even when the valid return intentionally does not include all the expenses that the lender expects.  Tax returns are intended for the IRS and must comply only with IRS regulations.  Lenders must request a separate statement of expenses if that is what they want.

If you know of any IRS code section (other than that dealing with claiming the EIC), then please share it.