Magazine article The CPA Journal

How Do Tax Returns Affect a Mortgage Application?

Magazine article The CPA Journal

How Do Tax Returns Affect a Mortgage Application?

Article excerpt

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 Kl). 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, depletion, 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 "mortgage 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. …

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