2013 Mortgage Loan Originator Income Tax Analysis

Income Tax Analysis

Mortgage Professionals

DisclaimerThe information presented in these training materials is

for general information only, and is based on

guidelines and practices generally accepted within

the mortgage finance industry and is not intended to

be all-inclusive.

You need to structure your loans based upon your

company guidelines and investor overlays.

IntroductionUnderwriting loans for the self-employed borrower is a

complex and challenging task. Each case is unique,

requiring a special set of skills to analyze this type of

borrower. The income of self-employed borrowers

must be analyzed differently due to the nature of self-

employment.

Determining whether borrowers can and will repay a

loan is difficult because obtaining an estimate of their

earnings from tax returns can be confusing.

IntroductionThe primary problem is that for self-employed

borrowers, their accountants are experts at reducing

tax liabilities by minimizing current net income, while

we as mortgage professionals rely on that same net

income as a gauge of their earnings.

The tax return reveals the borrower’s taxable income.

But what you are really looking for is the borrower’s

cash flow.

Cash flow is what is used to pay back the loan.

General Income Documentation

Requirements• Length of Employment

o A two-year history of receipt of stable income is generally required

• Stable and Predictable Incomeo Guidelines emphasize the continuity of a borrower’s stable income.

o Stable and predictable income is stressed more than stability of

employment.

o Less predictable income sources require more supporting documentation.

• Adequacy of Incomeo We must document and evaluate the borrower’s ability to repay the

mortgage.

• Continuity of Incomeo We must document the likelihood of continued receipt of income for at

least 3 years.

General Income Documentation

Requirements• We must assess the level of income in the

o past (historical patterns),

o present (exists today and is stable)

o and future (predictable and likely to continue).

• Declining income sources should be closely

reviewed to determine if the income may be used

for qualifying purposes. o a consistent decline might not be considered stable.

o In instances where there is sufficient information to support the use of the

declining income, only the most recent year lower income must be used.

Why Use Tax Returns?• Self-employed borrowers are not typical.

• There is no “independent third-party” to verify

employment and income.

• The most credible sources to verify income are the

tax returns that have been submitted to the IRS.

• Borrowers should sign the signature page of all tax

returns to indicate the forms provided are a true

and correct copy of those documents filed with the

IRS.

Personal Tax Returns• Personal tax returns reveal the borrower’s taxable income. But

what you are really looking for is the borrower’s cash flow.

• A cash flow analysis is required to examine a self-employed borrower’s personal income, including the business income or loss reported on the borrower’s personal tax returns.

• To analyze cash flow, tax statements are a starting point. Income is increased by the noncash expenses and decreased by any real losses or expenses that were not included in the taxable income.

• There are three key income/expense components that appear throughout the cash-flow analysis:o Noncash expenses (ex. depreciation)

o Recurring vs. nonrecurring income or loss (ex. business earnings vs. one-times sale of an asset)

o Losses and expenses limited by the IRS (ex. meals and entertainment)

Business Tax Returns• An analysis of business tax returns is used to

evaluate the consistency of profitability and the

potential for long-term earnings.

• This analysis of profitability can impact the

borrower’s cash flow ifo The business has positive sales and earnings trends;

o The business had adequate liquidity to support a withdrawal; and

o The borrower can document ownership and access to the income.

• Certain losses may need to be deducted.

• Note that guidelines can vary significantly on the

use of income from business sources. Consult your

company and/or investor guidelines.

Automated UnderwritingBoth Fannie Mae and Freddie Mac provide guidance on how to assess the loan applications of “self-employed borrowers” using their respective automated underwriting systems.

There are some basic rules for underwriting self-employed borrowers.

You should pay close attention to the documentation requirements listed on the underwriting findings report. Depending on the overall borrower profile, automated underwriting system results may differ from loan to loan.

For example, the underwriting findings report may only condition the loan for 1 year’s personal federal tax return.

Income that Requires Tax Returns

Self Employed IncomeAn individual receiving income from any of the following

sources must be qualified as self-employed:

• Borrower has an ownership interest of 25% or more in a

business. The business may be a sole proprietorship, a

general partnership, limited partnership, corporation, or S-

corporation;

• Borrowers whose combined business interests in the same

corporation are 25% or more of the total ownership.


Self Employed Income• A 2-year self-employment history, which includes verifying the

borrower has ownership in the business, is generally required to

ensure that the income is stable.

• Less than 2 years may be considered provided the borrower

has a recent 2 year history of successful employment in the

same occupation (or a related field) and they have been self-employed for at least 1 full tax year.

• Depending on Automated Underwriting Findings, the

requirement to obtain and review business tax returns may be

waived.

• Generally, a 24 month average is used to determine stable

gross monthly self-employed income. If wide fluctuations occur in the income, a 36 month average may be requested.


Partnership Income• A partnership is a legal form of business, which has

two or more partners. General partners have

unlimited personal liability for the debts and losses

while limited partners are only liable for the amount

of their investment in the partnership. The partners

control the partnership and the amount of control

each partner has is addressed in the partnership

agreement. In addition to an individual Form 1040,

the partnership will file a Schedule K-1 with Form

1065.


Partnership Income• When an applicant is a limited partner with less than 25%

interest, as in a law or accounting firm, and partnership

income is needed to qualify in addition to wages received,

the applicant must provide 2 years personal tax returns with

the Schedule K-1 for the partnership. The K-Is must be reviewed

to determine whether there are capital contributions being made. If there are capital contributions, the partnership

agreement must be obtained to determine the amount of

further required contributions. The earnings will be decreased

by the amount of capital contributions and the income

averaged over two years.


Partnership IncomeGuaranteed payments to partners may be used as income

based on providing the following documentation:

1. Two years of signed personal tax returns reflecting the receipt

of guaranteed payments, which will be reported income on

Schedule E, along with K-1s.

2. Two years signed 1065 Partnership Returns reflecting:

1. The income is stable, consistent, and likely to continue for

at least 3 years,

2. The business has positive sales and earnings trends,

3. The business has adequate liquidity to support the

withdrawal of earnings.

3. Income to be averaged over 2 years.


Commissioned Earnings• Commission income is a fee or percentage paid to the

employee for performing a service or is based on the dollar

amount of the goods and/or the number of units a person

sells. Some borrowers are paid a salary plus commission while

others receive only commission pay.

• If the borrower does not have a history of receiving commission income for at least 2-years, the income may only

be considered if there are solid compensating factors and a

future earnings trend can be demonstrated.


Commissioned Earnings• Borrowers who receive 25% or more of total income from

commission must be qualified using self-employed guidelines.

• Two years of personal tax returns and a 24 month average of

income/loss will be used to qualify.

• Income may be subject to fluctuations from year-to-year. If

there are large fluctuations, the appropriate adjustments made to average income used to qualify.

• AUS findings may provide relief for documentation

requirements.


Capital Gains• When income from capital gains will be used to qualify the

borrower, 2 years tax returns will be required to determine if it is

recurring and can be included or should be excluded from

the qualifying income.

• If a capital gain or loss appears to be a one-time occurrence,

it should not be considered when calculating income available.


Contract Employee• A Borrower who works on a contractual basis rather than as an

employee is treated as a self-employed borrower. Because

the individual may be released from employment at any time,

or as specified in their contract, employment history is crucial

when establishing income stability and the likelihood that it will

continue.

• All independent contractors will be treated as a self-employed

borrower. Two years signed and dated personal tax returns.

• AUS findings may provide relief for documentation

requirements.


Dividends and Interest• Interest income from bank accounts, bonds, savings bonds,

money market funds and stock dividends is acceptable if

verified.

• Such income should be adjusted appropriately if any or all the

assets are liquidated.

• The most recent preceding 2 years signed and dated tax returns, including applicable schedules, are required to verify

the amount and stability of the income as well as develop a

two-year average of the income.

• A 1099 form may be used in lieu of the tax returns to verify

interest and dividend income.

• File must also contain documentation to verify funds remain on deposit.


Rental Income• Rental income is substantiated with one or two years tax

returns as required by AUS.

• There are specific documentation requirements for

o “Rental Income from Property other than Subject Property”

and

o “Rental Income-Subject Property”.


Employed by Family Owned Business or Transaction-Interested Party

Borrowers who are employed by family or an interested party to

the property sale, purchase, or financing transaction must

provide:

• Verification of employment

• Most recent 2 years of personal tax returns, regardless of

percentage of ownership (if any) in business.

Most recent 2 years W2s; AND

• YTD paystub documenting at least 30 days of income.

• An IRS Form 4506T for all applicable tax returns for prior

years will be processed and transcripts used to verify

income documentation received.


Employed by Family Owned Business or Transaction-Interested Party

Current income reported on VOE or paystub must be compared

with previous years to determine reasonability and likelihood of

continuance.

• Large, unexplained increases must be closely analyzed.

• The borrower is not required to have a two year work

history with this same company to make this determination.

• If a borrower is recently employed with the family

owned/transaction-related party business, previous years’

earning ability should be compared with current salary

and the reasonability and likelihood of continuance

determined.


Auto AllowanceAuto allowance cannot be used to offset a car payment.

Auto allowance may be used to qualify subject to the following

verifications:

• Payments have been received a minimum of 2 years; and

• The amount included for income is the amount received from

the employer less the amount of expenses the applicant has

deducted on IRS Form 2106.

• If the allowance is less than the expenses the loss must be

deducted from qualifying income.

• Written verification from the employer documenting the

allowance.

• The amount must be verified on a paystub.

• Income or loss must be averaged over a two year period.


Clergy Member• Ministers or other members of the clergy are generally

considered self-employed unless exempted by IRS from self-

employment taxes. An exception from the IRS must be

provided, when applicable.

• Rental or housing allowance received may be considered

income for qualifying the applicant.

• The church may budget for educational, medical insurance,

life insurance, retirement, etc. to be paid on behalf of

applicant; however, these items will not be considered as

qualifying income, unless exempted by the IRS.

• The housing allowance, although not subject to federal

income taxes, is subject to self-employment taxes. Gross income on Schedule SE of the applicant’s 1040 should include

housing allowance paid


Seasonal / Variable Income• Income from seasonal employment may be considered if the

applicant has worked the same job “in season” for the past

two years and expects to be rehired for the next season. A

verification of employment (VOE) and the last two years (2) W-

2’s are required. The verification of employment must

reference the likelihood of borrower’s rehire. Seasonal income from W-2’s and paystubs must be averaged over a two year

period.

• If the borrower’s income has come from multiple seasonal

employers, in related or unrelated fields, two years tax returns

must also be obtained as support for income. Seasonal

income from tax returns must be averaged over a two year period.


Truck Driver• When a borrower is a truck driver, it is necessary to determine

whether the individual is a local, short-haul driver or an over-

the-road long haul driver. A long-haul driver will normally have

substantial non-reimbursed business expenses which should be

subtracted from income. Two years of tax returns must be

obtained to verify the amount of the business related expenses. Long haul drivers may be paid either by the hour or

by the mile. Income must be averaged over a two year

period and not less than 18 months.

• Local and short-haul drivers do not typically incur business

expenses but are can also be paid by the hour or by the mile.

Consideration of possible expenses must be given when qualifying these borrowers.


Unemployment Benefits• Unemployment income can be considered in stable monthly

income if it is common and customary for the borrower’s line

of work and likely to continue. The borrower must have a two

year history of receiving unemployment income along with a

two year history of seasonal income.

• Unemployment income is documented with two full years of tax returns and income will be averaged over a two year

period.

• Unemployment income cannot be used for qualifying income

when the borrower underwent long periods of unemployment

(i.e. greater than 26 weeks) due to factors other than seasonal

employment.


Union Employee• Union workers are members of a specific trade union and are often

skilled tradesperson (e.g., electricians, plumbers, roofers, etc.).

Workers can work for a single employer on a long-term basis or for

more than one employer throughout the year. At the completion of

a job, the Union will then refer the individual to a new employer.

• Union workers jobs may be seasonal and it is not uncommon for

individuals to receive unemployment during down time.

• If the borrower is a member of a local trade union and obtains

employment via these means, income can be verified by the

following:

• 2 years tax returns, OR 2 years of W-2s, OR a VOE from the Union for

earnings from all employers during the current year and a W-2 from

prior year.

• Qualifying income is calculated using a two year average of

documented income.

Tax Transcripts – General Guidance• The IRS transcripts should be reviewed for discrepancies that may

require additional documentation or re-calculation of income.

Additional reasons for discrepancies can include, but are not limited to:

o Capital gains/losses;

o Rental property income/losses; or

o Un-reimbursed employee expenses/Schedule 2106.

• In addition to reviewing the IRS transcripts for variances with income

documentation in file, the transcripts should be reviewed to identify

and address any additional discrepancies/red flags. These include, but

are not limited to:

o Undisclosed self-employment;

o Occupancy issues identified by address discrepancies;

o Undisclosed dependents; or

o Undisclosed rental and/or other properties.

Business Structures• Knowledge of the structure of the business that a self-

employed borrowers has will assist the lender in evaluating the

stability of the business and the degree of the borrower’s

involvement.

• There are four principal business structures—

o sole proprietorships,

o partnerships,

o corporations, and

o “S” corporations.

• Note: An LLC can elect to be taxed as a sole proprietor,

partnership, S corporation or C corporation (as long as they would otherwise qualify for such tax treatment), providing for

a great deal of flexibility.

Business Structures

Documentation Checklist

Sole ProprietorshipIf the borrower receives income from a sole proprietorship, the

following documentation is required:

• U.S. FEDERAL 1040 with all applicable schedules attached,

• SCHEDULE C (Profit or Loss from Business),

• SCHEDULE D (Capital Gains & Losses),

• SCHEDULE F (Profit or Loss from Farming), and

• YEAR-TO-DATE PROFIT & LOSS STATEMENT, as applicable.

Personal Income Statements


Partnership (General, Limited or LLC)If the borrower is a partner in a general or limited partnership, or is

a limited liability company member, the following

documentation is required:


• SCHEDULE E, PART II (Income or Loss from Partnerships),

• SCHEDULE K-1 (FORM 1065) (Partner’s Share of Income,

Deductions, Credits, etc.),

• FORM 1065 (U.S. Return of Partnership Income) with all

applicable schedules attached,

• YEAR-TO-DATE PROFIT & LOSS STATEMENT, as applicable, and

• PARTNERSHIP AGREEMENT (may be required).

Partnership Statements


CorporationIf the borrower receives income from a corporation, the following

documentation is required:


• FORM 1120 (U.S. Corporate Income Tax Return) with all

applicable schedules attached, and


Corporate Statements


S CorporationIf the borrower receives income from an S Corporation, the

following documentation is required:


• SCHEDULE E, PART II (Income or Loss from S Corporations),

• SCHEDULE K-1 (FORM 1120S) (Shareholder’s Share of Income,

Deductions, Credits, etc.),

• FORM 1120S (U.S. Income Tax Return for an S Corporation) with

all applicable schedules attached, and


S Corporation Statements

Flow of Tax Return Forms and

Supporting Schedules

Red Flags – Form 1040• Borrower indicates self-employed, owner of a sole proprietorship, yet 1040’s

disclose wages, salaries, tips, etc.

• Business income is inconsistent with the net income on the Schedule C.

• Deductions were made for one-half self-employed health insurance for a

borrower who does not claim self-employment.

• Even dollar amounts for income or deductions.

• Evidence of whiteout or strikeovers, alterations or varied handwriting within

return.

• Handwritten tax returns prepared by a professional tax preparer.

• High-income borrower and self-prepared tax returns.

• High-income borrower with few or no deductions.

• Name, address, social security number, or corporation is inconsistent with

information in the loan file.

• No deductions have been taken or incorrect deductions have been taken.

• Obvious income/deduction calculations.

• Occupation differs from what was stated on the 1003.

Red Flags – Form 1040• Paid tax preparer does not disclose tax ID.

• Paid tax preparer signs taxpayer’s copy.

• Personal information does not agree with the information in the loan file.

• Real Estate taxes paid, but no property shown on Schedule of Real Estate.

• Schedules missing from file.

• Self-employed borrower that does not reflect estimated tax payments

(Schedule SE).

• Self-employed borrower who shows salaried wages instead of business

income.

• Tax returns are not signed/dated by borrower.

• The number of dependents does not agree with the 1003.

• The type of handwriting varies within the return.

• Unemployment compensation was claimed but the file does not show a gap

in employment or that there is seasonal employment.

• W-2 information does not match the figures reported on the 1040.

Red Flags – Schedule A• Borrower pays large amounts of interest, but few creditors are shown on the

mortgage application or credit report.

• Real estate owned, but no deductions taken for real estate taxes or mortgage

interest paid.

• Real estate taxes or mortgage interest reported, but no real estate owned.

Red Flags – Schedule B• Stock owned, but no dividend income reported.

• Interest income reported is not consistent with cash assets in the bank.

• Source and/or amount of income are inconsistent with loan application.

Red Flags – Schedule C• Borrower’s wages are paid, but no tax expense is claimed.

• Business expenses are not consistent with the type of business (i.e., truck driver

doesn’t claim a car or truck expense).

• Depreciation deduction for real estate, but ownership of real estate is not

disclosed (vice versa).

• Income appears high for the type of business listed on schedule C.

• Income does not agree with total income on 1099 forms.

• Interest expense, but borrower does not disclose a related loan.

• No “cost of goods sold” on retail or similar type of business.

• No deduction for depreciation (usually some type of equipment that qualifies).

• No IRA or Keogh deduction.

• No salary expense to operate business.

• Numbers are incorrectly added.

• The borrower takes a depreciation deduction for real estate that is not disclosed

on the application.

• There are no deductions for tax and licenses.

Red Flags – Schedule E• Properties listed not disclosed on the loan application.

• Borrower income/loss not disclosed on loan application.

• Mortgage interest deduction taken but debt is not disclosed on the loan

application.

• Net income is inconsistent with amount disclosed on loan application.

• Partnership(s) and/or S Corporation(s) listed on Schedule E Part II and there is

no reference listed on the loan application.

Income Calculation Worksheet• Many people are under the misconception that investors

require a specific cash flow work sheet be used. In fact,

Fannie Mae, Freddie Mac and most investors have no

requirement about what form to use when underwriting the

self-employed borrower.

• What is required by both Fannie Mae and Freddie Mac, and almost all investors, is that the lender clearly shows how

income was determined.

• The form you use is up to you – it’s either dictated by your

investor guidelines, company policy or your comfort level with

one method or the other.

Income Calculation WorksheetADJUSTED GROSS INCOME (AGI)

• Start with the Total Income amount that appears on Line 22.

• The total income that appears here includes income and loss

from supporting schedules.

• As you analyze the tax return, you will add or subtract from this

total income, depending on the types of revenue and

expenses you find.

Income Calculation WorksheetSCHEDULE ANALYSIS METHOD (SAM)

• Start with the amount that appears on Line 7: Wages, Salaries,

Tips, etc.

• As you analyze the tax return, you will also review separate tax

schedules filed by the borrower, such as Schedule A, Itemized

Deductions or Schedule C, Profit or Loss from Business.

• Because the income or loss is listed separately on each

schedule, you can clearly evaluate the level and stability of

the different sources of income.

• Consequently, you will add income or subtract

losses/expenses from the amount on Line 7.

2013 Mortgage Loan Originator Income Tax Analysis

Real Estate

Transcript of 2013 Mortgage Loan Originator Income Tax Analysis