Dallas-Fort Worth Real Estate Investor Club

Investor Tax Return Conventional Qualifying Hints

  • 30 Jan 2017 4:23 PM
    Message # 4576601

    Today you are going to get some really important “behind-the-scenes” information on how a bank examines your tax returns.  Often we submit our application for a conventional loan to a bank, someone tells us that it’s with an “underwriter”, and a few days later they tell us “yes” or “no”.  If you are lucky they will tell you some generic response on your approval, or lack-there-of, but no one tells you how they came to their conclusion.  Today that will change!  You will know exactly how a bank reviews your tax returns! 

    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 I have seen many tax returns where people listed an item in an alternative section of the returns. For example, one tax return specifically they had Line 44A blank, so essentially $0…but then later on they listed vehicle miles in a separate line item on a different schedule.  So the tax advantage by listing it in one section as opposed to another was 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 rehabbed 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(16A & 17), 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 "veil of underwriting".  If you have questions about these items please feel free to ask.  


    Last modified: 01 Feb 2017 1:52 PM | Andrew Postell
  • 31 Jan 2017 7:42 AM
    Reply # 4577440 on 4576601

    Hey Andrew, thanks very much for taking the time to lay this info out very clearly and succinctly.

    Appreciate it!

    Bill Barton


  • 31 Jan 2017 7:59 AM
    Reply # 4577468 on 4576601

    Thank you Andrew.

  • 31 Jan 2017 12:49 PM
    Reply # 4578063 on 4576601

    Thank you, Andrew! Excellent discussion on something that I really haven't given much thought to.

    In terms of where to put expenses "One-Time Expense", "Repair", "Other". I believe if you spent money on the rehab, it should get added to the cost basis of the property, then depreciated over 27.5 years. However, putting in a new HVAC, water heater, roof, tenant make ready, where do those go? I'm really not sure, anyone have an ideas about that?

    Thanks!

    Last modified: 31 Jan 2017 12:53 PM | Hiron Fernando
  • 07 Feb 2017 10:10 PM
    Reply # 4597076 on 4576601
    Deleted user

    Great info !


    Thanks Andrew 

  • 12 Feb 2017 2:58 PM
    Reply # 4605728 on 4576601
    Deleted user

    Yes, thanks Andrew.

    Along these lines, I'm doing my tax return... But it's difficult for me to figure out from the Settlement Statement (from last year's RE investment) exactly which Buyer Charges are tax deductible. Is there a general guideline to follow? 

    Are all (or any) of the lender fees under the New Loan section deductible? (Obviously, the interest is.)
    Are all (or any) of the Title/Escrow fees deductible?

    Also, at a recent club meeting, Don McCartney talked about deducting training expenses (and whether they had to be amortized). Assuming my situation meets the criteria to be deducted all at once, where does one put that on Schedule E?  "Other" or "Legal and professional fees"?

    I'll go ahead and make a blanket disclaimer for anyone who responds - I fully understand that you are not a tax attorney nor an accountant, I will consider your comments in that light, and I will take full responsibility for anything I do that may or may not be a result of your comments. :-)

    Thanks, Paula


    Last modified: 12 Feb 2017 3:05 PM | Robin Carriger (Administrator)
  • 14 Feb 2017 11:24 AM
    Reply # 4608857 on 4578063
    Hiron Fernando wrote:

    Thank you, Andrew! Excellent discussion on something that I really haven't given much thought to.

    In terms of where to put expenses "One-Time Expense", "Repair", "Other". I believe if you spent money on the rehab, it should get added to the cost basis of the property, then depreciated over 27.5 years. However, putting in a new HVAC, water heater, roof, tenant make ready, where do those go? I'm really not sure, anyone have an ideas about that?

    Thanks!


    Hiron,

    You are correct that the money spent on rehab prior to the property being "placed in service" generally gets added to the cost basis of the property.  If the property is going to be kept for the production of income, then you start depreciating or amortizing the cost basis starting with the placed in service date, using various time frames, depending on the asset class.  The most common asset class for small real estate investors is residential buildings, which get written off over 27.5 years.  Other components, such as fences and land improvements can be written off over 15 years.  Loan fees are amortized over the life of the loan.

    You asked about where to put HVAC, water heater, roof, and tenant make ready costs.  These fall under the IRS repair regulations, which often allow you to deduct them as business expenses if the property has been placed in service already.  If it's a recurring item such as tenant make ready, which is likely to reoccur within 10 years, you can generally deduct the costs.  Removing and replacing the top layer of a roof in order to stop leaks can also be deducted.  Other "big ticket" items such as hot water heaters and HVAC repairs can be deducted if they were previously operational,  the system "breaks", and you go in to replace the broken unit with a similar new one, provided the total cost is less than $2500.  This falls under the de minimus exception for items less than $2500.  (The limit used to be $500, but the IRS raised it recently.)  The restriction here is that you cannot replace the unit with anything significantly better than what was there before, so you have to go back with similar components.  Upgrades or "betterments" generally have to be capitalized. 

    Hope this helps.

    Donald McCartney, CPA

     

  • 14 Feb 2017 11:40 AM
    Reply # 4608883 on 4605728
    P Robertson wrote:

    Yes, thanks Andrew.

    Along these lines, I'm doing my tax return... But it's difficult for me to figure out from the Settlement Statement (from last year's RE investment) exactly which Buyer Charges are tax deductible. Is there a general guideline to follow? 

    Are all (or any) of the lender fees under the New Loan section deductible? (Obviously, the interest is.)
    Are all (or any) of the Title/Escrow fees deductible?

    Also, at a recent club meeting, Don McCartney talked about deducting training expenses (and whether they had to be amortized). Assuming my situation meets the criteria to be deducted all at once, where does one put that on Schedule E?  "Other" or "Legal and professional fees"?

    I'll go ahead and make a blanket disclaimer for anyone who responds - I fully understand that you are not a tax attorney nor an accountant, I will consider your comments in that light, and I will take full responsibility for anything I do that may or may not be a result of your comments. :-)

    Thanks, Paula

     


    Paula,

    Hi, this is Don.  I'll try to address some of your questions, but keep in mind that these comments are general in nature since I'm not seeing the details of your individual situation.  My first comment is that you should probably not be trying to do this yourself, because the rules in these areas are very complex.

    The lender fees are generally amortized over the life of the loan, assuming you are holding the property for the production of income.  If you are planning on flipping the property, they should remain as part of the cost basis of the property until sold.  Since you are talking about putting it on Schedule E, I'm going under the assumption that you are planning on holding the property as a rental, which would allow you to start amortizing those costs when the property is placed in service.

    The title and escrow fees should be capitalized and depreciated over the useful life of the assets involved, usually it's 27.5 years for residential property.  The estimated cost of the land should be separated out, because it is non depreciable.  However, land improvements can be depreciated over 15 years.

    The deductible portion of training fees can be either put under "Startup Expenses", if incurred prior to the startup date, or as "Continuing Education" if incurred afterwards.  Be careful, because there's other limitations and requirements you have to meet to claim these deductions.  Any capitalized portion should be amortized over 15 years.  

    Hope this helps.

    Don McCartney, CPA

     

     

     

  • 15 Feb 2017 11:30 AM
    Reply # 4610805 on 4576601

    Thanks for the replies Don!  Greatly appreciated and good information to have!

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