SEPTEMBER 2011 / THE CPA JOURNAL52

By Michael Moskowitz

Tax returns have long been animportant part of the mortgageunderwriting process, taking a brief

hiatus during the no–income-verificationdays of the real estate boom in the early2000s. Because the current economic envi-ronment has required the review of taxreturns to be more in-depth than it has beenin recent memory, it benefits every CPAto understand how a residential mortgageunderwriter analyzes an applicant’s taxreturns. This knowledge will help CPAsadvise self-employed individuals who maybe considering a home purchase and loan.

Tax returns are vital to the underwritingprocess, particularly for self-employed bor-rowers, which the mortgage industry gen-erally determines to be anyone with a 25%or greater ownership in a business. This isone of the first items an underwriter willlook for on the respective form or schedule(for example, Schedules E and K1). Onceit has been determined that a borrower isself-employed, the underwriter will begin toanalyze the business for such factors asstability of income, location and nature ofthe business, demand for the product or ser-vice provided, financial strength, and theability to continue generating sufficientincome to pay the mortgage.

Underwriting guidelines usually requirea self-employed borrower to have been inbusiness for at least two years. There aresome instances when a shorter time is allowable, but never less than 12months. For this 12-month exception tobe made, the most recent year’s taxreturns must demonstrate that the bor-rower had been able to sustain the sameincome as in his previous employmentand be in the same line of work. Usingthis two-year guideline as a reference, thedocumentation requirements for the self-employed borrower usually include the

personal and business tax returns for thetrailing two years.

What Underwriters Look ForUnderwriters generally begin with the

loan applicant’s personal tax returns anddevelop a cash flow analysis using a formsuch as Fannie Mae Form 1084. A quick

look at this form will demonstrate whichitems stand out on Forms 1040, 1065, 1120and 1120S. This form walks the under-writer through a schedule analysis, high-lighting the items that can be added backor must be deducted to determine the qual-ifying income. General themes through-out the analysis are that non-cash itemssuch as depreciation can be added back toincome, and nonrecurring items such ascapital gains must be deducted. Items thatmay be added back to income include:nonrecurring/other loss, net operating lossand special deductions, depreciation, deple-

tion, and amortization. Items that must bededucted include: nonrecurring/otherincome, mortgage notes payable in lessthan one year, and the meals and enter-tainment 50% exclusion.

Knowing this information will help aCPA understand why a mortgage bank isasking if the amount listed on the “mort-

gage notes payable in less than 12 months”line will be rolled over, or if it is actuallydue and payable. It can have a largeeffect on the business cash flow and,thus, on the borrower’s ability to qualifyfor a mortgage.

Underwriters may look in more detail atthe balance sheet of the business, theowner/partner capital account, and theincome reconciliation to determine if the bor-rower is increasing an equity position ordrawing the maximum out of the businesseach year. This is more relevant for busi-nesses with a shorter history (i.e., less than

How Do Tax Returns Affect a Mortgage Application?

F I N A N C E

p e r s o n a l f i n a n c i a l p l a n n i n g

five years or for borrowers who are push-ing the limits of acceptable debt ratios). Anaccountant who can provide an updatedincome statement can often help a borrow-er who has been in business a relatively shorttime and has some fluctuating income.Underwriters will generally look favorablyon a business where the accountant isinvolved and can opine as to the seasonali-ty or other reasons for variable cash flow,which might not be explained merely byreviewing the tax returns.

Unreimbursed ExpensesIn recent years, mortgage underwriting

guidelines tightened to the point where aborrower’s tax returns are present in almostevery file, and it has become standard prac-tice for lenders to verify tax returnsdirectly with the IRS, even for salaried orfixed-income borrowers.

This emphasis on tax returns bringsanother issue to light that was not rele-vant in the past: IRS Form 2106 andunreimbursed business expenses.Previously analyzed only for borrowerswhose income consisted of 25% or morecommissions, unreimbursed expenses havenow been brought into play for all bor-rowers. As a result, Form 2106 can oftenbe the difference between qualifying andnot qualifying (or qualifying for a lowerloan 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 $1,875per month. If this borrower deducts $5,000in unreimbursed business expenses, herqualifying income becomes $45,000 andher maximum annual expenses are reducedto $20,250, or $1,687.50 per month. Theseexpenses include the principal, interest,taxes, and insurance on the loan, as wellas any debts that appear on the credit report(e.g., credit card payments and install-ment loans). Assuming the credit reportexpenses are fixed, this is a direct reduc-tion in loan amount. If we are to assumethe rate is 4.25% and the term is 30years, and a total of $400 a month forreal estate taxes and hazard insurance,this is a reduction of about $38,000 in theloan amount. Assuming no additional debt,the borrower’s potential loan amount wasreduced from approximately $300,000 to$262,000.

Knowledge Is KeyThe increased access to and focus on

tax return analysis has been one of themany changes that has taken place inthe mortgage industry over the past fewyears, making it more difficult than it hasbeen in recent memory to be approvedfor a loan. CPAs with knowledge of thischange, as well as the insight into whatexactly has changed, have a leg upwhen discussing home purchases and refi-nancing with clients. They will not only

be able to explain to a borrower the waythat a lender is looking at his cash flow—they will also be able to explain the bor-rower’s business more effectively to alender, if necessary, and possibly makethe difference between getting a loan ornot getting one. ❑

Michael Moskowitz, CPA, is president ofEquity Now in New York, N.Y. He can bereached at mmoskowitz@equitynow.com.

53SEPTEMBER 2011 / THE CPA JOURNAL

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.