How Do Tax Returns Affect a Mortgage Application?

FINANCE personal financial planning

How Do Tax Returns Affect a Mortgage Application?

By Michael Moskowitz

Tax returns have long been an important part of the mortgage underwriting process, taking a brief hiatus during the no?income-verification days of the real estate boom in the early 2000s. Because the current economic environment has required the review of tax returns to be more in-depth than it has been in recent memory, it benefits every CPA to understand how a residential mortgage underwriter analyzes an applicant's tax returns. This knowledge will help CPAs advise self-employed individuals who may be considering a home purchase and loan.

Tax returns are vital to the underwriting process, particularly for self-employed borrowers, which the mortgage industry generally determines to be anyone with a 25% or greater ownership in a business. This is one of the first items an underwriter will look for on the respective form or schedule (for example, Schedules E and K1). Once it has been determined that a borrower is self-employed, the underwriter will begin to analyze the business for such factors as stability of income, location and nature of the business, demand for the product or service provided, financial strength, and the ability to continue generating sufficient income to pay the mortgage.

Underwriting guidelines usually require a self-employed borrower to have been in business for at least two years. There are some instances when a shorter time is allowable, but never less than 12 months. For this 12-month exception to be made, the most recent year's tax returns must demonstrate that the borrower had been able to sustain the same income as in his previous employment and be in the same line of work. Using this two-year guideline as a reference, the documentation requirements for the selfemployed borrower usually include the

personal and business tax returns for the trailing two years. What Underwriters Look For

Underwriters generally begin with the loan applicant's personal tax returns and develop a cash flow analysis using a form such as Fannie Mae Form 1084. A quick

look at this form will demonstrate which items stand out on Forms 1040, 1065, 1120 and 1120S. This form walks the underwriter through a schedule analysis, highlighting the items that can be added back or must be deducted to determine the qualifying income. General themes throughout the analysis are that non-cash items such as depreciation can be added back to income, and nonrecurring items such as capital gains must be deducted. Items that may be added back to income include: nonrecurring/other loss, net operating loss and special deductions, depreciation, deple-

tion, and amortization. Items that must be deducted include: nonrecurring/other income, mortgage notes payable in less than one year, and the meals and entertainment 50% exclusion.

Knowing this information will help a CPA understand why a mortgage bank is asking if the amount listed on the "mort-

gage notes payable in less than 12 months" line will be rolled over, or if it is actually due and payable. It can have a large effect on the business cash flow and, thus, on the borrower's ability to qualify for a mortgage.

Underwriters may look in more detail at the balance sheet of the business, the owner/partner capital account, and the income reconciliation to determine if the borrower is increasing an equity position or drawing the maximum out of the business each year. This is more relevant for businesses with a shorter history (i.e., less than

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five years or for borrowers who are pushing the limits of acceptable debt ratios). An accountant who can provide an updated income statement can often help a borrower who has been in business a relatively short time and has some fluctuating income. Underwriters will generally look favorably on a business where the accountant is involved and can opine as to the seasonality or other reasons for variable cash flow, which might not be explained merely by reviewing the tax returns.

Unreimbursed Expenses In recent years, mortgage underwriting

guidelines tightened to the point where a borrower's tax returns are present in almost every file, and it has become standard practice for lenders to verify tax returns directly with the IRS, even for salaried or fixed-income borrowers.

This emphasis on tax returns brings another issue to light that was not relevant in the past: IRS Form 2106 and unreimbursed business expenses. Previously analyzed only for borrowers whose income consisted of 25% or more commissions, unreimbursed expenses have now been brought into play for all borrowers. As a result, Form 2106 can often be the difference between qualifying and not qualifying (or qualifying for a lower loan amount).

Example. A borrower who makes $50,000 per year and qualifies at a 45% debt-to-income ratio can qualify with $22,500 in annual expenses, or $1,875 per month. If this borrower deducts $5,000 in unreimbursed business expenses, her qualifying income becomes $45,000 and her maximum annual expenses are reduced to $20,250, or $1,687.50 per month. These expenses include the principal, interest, taxes, and insurance on the loan, as well as any debts that appear on the credit report (e.g., credit card payments and installment loans). Assuming the credit report expenses are fixed, this is a direct reduction in loan amount. If we are to assume the rate is 4.25% and the term is 30 years, and a total of $400 a month for real estate taxes and hazard insurance, this is a reduction of about $38,000 in the loan amount. Assuming no additional debt, the borrower's potential loan amount was reduced from approximately $300,000 to $262,000.

The increased access to and focus on tax return analysis has been one of the many changes that has taken place

in the mortgage industry over the past few years.

Knowledge Is Key The increased access to and focus on

tax return analysis has been one of the many changes that has taken place in the mortgage industry over the past few years, making it more difficult than it has been in recent memory to be approved for a loan. CPAs with knowledge of this change, as well as the insight into what exactly has changed, have a leg up when discussing home purchases and refinancing with clients. They will not only

be able to explain to a borrower the way

that a lender is looking at his cash flow--

they will also be able to explain the bor-

rower's business more effectively to a

lender, if necessary, and possibly make

the difference between getting a loan or

not getting one.

Michael Moskowitz, CPA, is president of Equity Now in New York, N.Y. He can be reached at mmoskowitz@.

SEPTEMBER 2011 / THE CPA JOURNAL

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