Tax Returns – When Do They Need To See Tax Returns?

Tax Returns
  1. A borrower is considered self-employed when they own 25% or more interest in a business.  This is when the taxes would be required to calculate the borrower’s income.
  2. When 25% or more of the income is from other than base salary.  Examples of this are if the borrower’s income comes 25% or more from overtime, bonuses, commissions or piecework.
  3. Tax Returns are necessary if the borrower works for a family-owned business.
  4. If you have rental income they need to see your taxes to determine if you are making a net income or loss from the rental income.

How the Underwriter Calculates Income from Tax Returns?

The loan processor is actually the first person to evaluate the income from the tax returns.  Once they receive the tax returns from the borrower they us an analysis form.  This form is completed to calculate an average monthly income.

An analysis form must be completed to develop an average monthly income by using at least two full years of the borrower’s tax returns.  Income from the year-to-date profit and loss statement may be included in determining the average monthly income, if that income is comparable to the two previous years’ earnings.

There are two acceptable methods of analyzing tax returns: the schedule analysis method (SAM) and the adjusted gross income method (AGI).

Schedule Analysis Method (SAM)

The function of this method is to review the tax returns, schedule by schedule, and extract the income components that are appropriate to be included in “effective income” created from the business or vocation.

From Schedule C, Form 1040

To the Net Profit or Loss figure, add back depletion and depreciation, and subtract the 20% meals and entertainment exclusion.

From Schedule D, Form 1040

Capital Gain or Loss is generally a one-time transaction, and should not be included in determining income.  If the borrower has a constant turnover of assets that produces capital gains/losses (such as real estate investor or developer) these may be considered. Three years’ tax returns would be needed to support an earnings average.

From Schedule E, Part II

Income or Loss from Partnerships and S Corporations is determined by reviewing the K-1 form:

Effective Income from Partnerships = Ordinary Income (Loss) + Guaranteed Payments.

Effective Income from S Corporations = Ordinary Income (Loss) + Other income (Loss)

From Schedule F, Form 1040

To “Profit (Loss) from Farming” net profit figure, add back depreciation.

Form 2106, Form 1040

The Employee Business Expense should be analyzed for a borrower with W-2 corporate income.  This form contains business expenses paid by the borrower and not reimbursed by the corporation, that should be deducted from income.

From Form 1040, with attached W-2 Forms

Compensation of Officers by a Corporation is found on the front page of the 1040, and supported by attached W-2 forms.  The most current “Corporate Resolution” on the subject of officers’ salaries will indicate the amount established for next years salary.

Form 1040 has two Schedules that are sources of income, but are not included in the SAM calculation, as the income is not generated by business activity.  These two kinds of income are shown on page one of the application as “Other Income” or “Net Rent”.

From Schedule B, Form 1040

Income from interest and dividends can be used if the asset that produces the income will not be extinguished at closing.  (Interest from a savings account will not be available to help make future mortgage payments if the funds are all spent in closing).

From Schedule E, 1040

Depreciation may be added back to “Income from Rents and Royalties” net profit figure.

Adjusted Gross Income Method (AGI)

The mechanics of this method involve starting with Adjusted Gross Income from the front of the 1040, and either adding or subtracting specific income components found elsewhere in the return.

“Income Section” of Form 1040 (front page):  If an amount is entered on the Wages, Salaries and Tips line and the borrower is self-employed, you should investigate.  It could mean that the borrower operates as a corporation and pays himself or herself a salary.  It could also mean that the borrower’s spouse is employed, in which case the spouse’s income should be subtracted from the Adjusted Gross Income calculation.  (It is not part of the business earnings being analyzed.)

Taxable Interest Income is found on Schedule B.  It may be counted as income if a two-year track record can be documented, and the asset that produces the income will not be used for closing expenses.  It is deducted from the AGI calculation, since it is not part of the business earnings being evaluated by this form.

Tax Exempt Interest Income may be included only if it has been received for two years and is expected to continue.  It is not included in the “Adjusted Gross Income” figure on page 1 of the 1040; therefore, it must be added in when completing the AGI-method form (if it is to be included in effective income).

Dividend Income is treated like “Taxable Interest Income” above.

Taxable Refunds of State and Local Income Taxes must be deducted from AGI, since it is not recurring.

Alimony Received may be included in effective income (as long as it will continue for three years, and a one year history of receipts can be documented), but it is not a part of the self-employment income stream being analyzed and is therefore deducted from AGI.

Business Income or Loss – from Schedule C provides spaces to add back Depreciation and/or Depletion, and subtract the 20% Meals and Entertainment exclusion.

Capital Gains or Loss – from Schedule D provides a space to deduct gains and add back losses in this category.

IRA Distributions (non-Taxable) are added, since they are not included in the initial calculation of AGI.

Pensions and Annuities (Non-Taxable) are added for the same reason, provided the income will continue for 3 years.

Schedule E – Depreciation/Depletion can be added back.  This is the depreciation or depletion incurred in connection with income from rents and royalties.

Schedule F – Depreciation can be added back.  This is incurred in connection with a farm income.

Unemployment Compensation may be considered if it is properly documented as regular income with a two year history (i.e. seasonal employment).  Otherwise it is deducted from AGI.

Social Security Benefits (Non-Taxable) may be included if they have a remaining term of at least three years.  Add back the non-taxable portion.

In the Adjustment Section portion of the form, “IRA Deductions”, Self-Employed Health Insurance, Keogh Retirement Plan, Penalty for Early Withdrawal, and Alimony Paid may be added back.

Employees Business Expenses (Form 2106) is part of the “Additional Schedules” forms and reflects actual out-of-pocket expenses which must be deducted from AGI.  Amortization, Form (4562) can be added back to AGI.  Un-allowed Losses (Form 8582) must be deducted from AGI.  Carryovers (Form 8582) can be added back.

Parts B and C of the “SAM Method” and “AGI Method” forms are for evaluating business tax returns for additional income.  The primary purpose for reviewing the business tax return is to analyze the business’ financial strength and to confirm that it will continue to generate the income the owner/borrower needs to qualify for the requested mortgage.  When the individual tax return confirms sufficient borrower income and the business taxes return indicates a viable company, it is not necessary to investigate the business any further.  However, if the borrower needs to (and has the legal right to) draw additional income from the corporation, further evaluation is necessary.

Evaluating Corporate Tax Returns – Form 1120

Part B of the “SAM” and “AGI” method forms capture the borrower’s share of after-tax income and non-cash expenses, after deducting obligations payable in less than one year from the corporate tax returns.  Beginning with the taxable income, the figure is adjusted by the items listed below.  The result is multiplied by the borrower’s percentage of ownership to determine the amount that can be considered in effective income.  The borrower’s right to these funds must be verified by corporate resolution or comparable documentation.

Many corporation operate on a fiscal year different from the calendar year.  In these cases, it is necessary to make time adjustments to relate the corporate income to the individual tax return, as the latter is on a calendar year.  The borrower’s percentage of ownership can be determined from the “Compensation of Officers” section of the corporation tax return.

  1. “Total Tax” is deducted.  “Depreciation/Depletion” is added back to determine after-tax income.
  2.  “Mortgages, notes, bonds payable in less than one year” is a figure found in the balance sheet section of the corporate tax return, and must be deducted.  These are debts payable in the next year and funds must be available to meet these obligations.
  3. “Dividend Income” paid to the borrower by the corporation (shown on Schedule B of the borrower’s individual tax return) must be deducted, since it is incorporated into the “taxable income” figure.  Without this deduction, the borrower would be given credit for the same income twice.

Evaluating S Corporation Tax Returns

Part C of both forms is completed to analyze both S Corporations and Partnerships.  The primary source of income for an owner of an S Corporation comes from W-2 wages, which are traced to the Compensation of Officers line of forms 1120S and the individual’s Form 1040.  Depreciation and Depletion from the S Corporation tax returns can be proportionately added back to the borrower’s income since they are actually non-cash expenses.  This combined figure must then be reduced by the total obligations that are payable in less then one year (to make sure the business will be able to meet its short-term obligations).  The Schedule K-1 (Form 1120S) must be reviewed to determine the borrower’s percentage of ownership.

Evaluating Partnership Returns

Both general and limited partnerships use the IRS Form 1065 for filing tax returns.  The partnership income is carried over to the individual tax return by Schedule K-1 (Form 1065) and is reflected on Schedule E.  Depreciation and depletion from the partnership return can be added back. As with the S Corporation, the combined figure is reduced by the total obligations payable in less than one year.  Schedule K-1 (Form 1065) is used to determine the borrower’s percentage of ownership.

YEAR-TO-DATE PROFIT AND LOSS:  Income from the year-to-date profit and loss statement may be included in determining the average monthly income, only if that income is comparable to the two previous years’ earnings.  If year-to-date income is substantially greater than the previous two years’, it cannot be considered.  If the year-to-date income figures are showing a downward trend when compared with the past two years’, an explanation from the borrower will be required.

Income figures for the current year that reflect declining income when compared with the past two years’ may be explained by the seasonal nature of the business, such as fishing or farming.  However, if the average income is truly lower than in the past, it is possible that the business is losing profitability, and may not be considered as qualifying income for mortgage loan


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