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.