Why mortgage lenders want tax returns

With mortgage rates at historical lows, are you shopping for a home mortgage loan?  Prepare to hand over real proof of your taxable income including tax returns.  Sorry no more “No Doc” loans.

During the housing boom, lenders rarely required borrowers to provide copies of federal tax returns.  Some lender programs required no proof of income

But today, lenders often ask borrowers to turn over entire tax returns regardless whether or not you are self employed.

Many borrowers still think they can bring in the first two pages of the tax return or just their W-2’s. What they need to bring is the full tax return and all schedules because a person’s full income picture is contained in the entire set of documents, not just the first two pages.  Some people try and hide the fact that they may have a side business that is loosing money.

Borrowers may also will be required to sign a IRS Form 4506-T, which allows the lender to retrieve a tax transcript from the Internal Revenue Service.  This is done to validate the tax returns that are provided to the lender.  Lenders use the 4506-T tax transcript to compare the borrower’s W-2s or 1040 tax returns and verify  his or her reported income. If the numbers match, all is well. If not, the lender will dig deeper.

Why the sudden interest in borrowers’ tax returns? The short answer is lenders are looking for income irregularities and evidence of loan fraud.

That means the lender not only will look at reported income, but also at other items such as:

Un-reimbursed employee business expenses:   These so-called “2106 business expenses” typically are subtracted from income.

Examples include uniforms, union dues, mileage, expenses related to a cell phone used for business, marketing costs and training costs.

If somebody makes $80,000 a year, but writes off $20,000 in unreimbursed business expenses, that is allowing them to reduce their taxable income, but we have to subtract that for qualifying purposes because these expenses were part of their ability to make the $80,000 in income.

Rental property income:  This income must be documented and shown on the tax return, unless the property was purchased in the current calendar year. In that case, the rent must appear on consecutive monthly bank statements.

If you bring in $1,000 a month in rental income, but you have $900 a month in expenses for owning the property, then you really only have $100 a month in positive rental income and that is what can be used for qualifying.  If you take in $1,000 a month, and you don’t report that on your tax returns, you can’t use that income at all as you are not reporting your income to the government and most loans now are government backed.

Business losses: These include losses incurred by a spouse’s business.

For example, suppose one spouse earns $100,000 per year as an employee. The other spouse has a business that generated a $40,000 loss shown as a write-off on the couple’s tax return. The lender will subtract $40,000 from $100,000 to yield a combined taxable income of $60,000. That might not be enough income to qualify for as large a loan as the borrower wanted.

Depreciation expenses: On the flip side, depreciation expense taken on a home office, business equipment or other asset could increase a borrower’s loan-qualifying income as it is generally added back to the income.

Capital gains: These also may be counted as income — or not depending on whether the borrower can prove that they have been earning it for the past 2 years and that it is likely to continue.  This “likely to continue” would be very hard to prove.

Too many tax deductions

Lenders’ scrutiny of tax returns can present a big challenge for borrowers who are self-employed.

Many self employed borrowers, such as Realtors to shoe store owners,  are having a really difficult time getting loans because their accountants and bookkeepers are trained to minimize their income to save them on taxes.

The solution isn’t easy: Taxpayers may need to “bite the bullet,”  and build up their taxable income for two years before they can qualify for a loan. Some may have to forgo deductions to which they believe they are entitled and pay more income tax so they can show more income on their tax return to qualify for a loan.

Borrowers who try to amend a prior year’s tax return to show more income after the fact may be disappointed to learn this strategy won’t work. Instead, an amended tax return can trigger a loan denial.

The very creative loan officer would say, ‘Go back and amend your tax return to show some income, so you can qualify,’”   However, underwriters caught on to this, so now there is a new rule that says you cannot qualify for a mortgage if your tax return has been amended for the sole purpose of boosting your income.