Once or twice a year, a tax client comes to me exasperated because their mortgage broker is not including all of their income in their debt analysis. The most recent situation was one where the broker didn’t understand that a shareholder of an S Corp will typically show 2 income streams on their Form 1040, one for corporate wages and one for a distribution from the corporation. Adding the distribution to the mix resulted in the client qualifying for the mortgage that was applied for.
This happens rarely in my business but when you consider that I prepare a very small percentage of all the returns filed for this area, it’s possible that this kind of thing occurs more than one would think.
When income is considered for a mortgage, it is quite common for a number of items to be added back into the income calculation, especially when there is a business involved. These addbacks serve to increase income that is used in the debt-to-income ratio. More income means more allowable debt.
This often happens because the tax system allows a number of tax breaks for businesses that serve to reduce taxable income. Commonly used strategies move some of your ‘personal’ expenses into the business expense column, such as home office, vehicle depreciation, etc. These are loved by businesses because they lower business taxable income, thus lowering business taxes. But these aren’t really additional expenses. For example, the home office deduction simply allows you to claim as a deduction expenses incurred simply by using a part of your home for business. It’s not actually reducing income available to the business.
Depreciation is another expense that is very common in all kinds of businesses. These deductions are great for your tax bill, but by reducing taxable income, a very important number used by mortgage brokers, your debt to income ratio is increased. This harms your mortgage eligibility or can increase the interest rate you qualify for or both.
We routinely work with small business owners when they’re in the process of buying a home to help all involved understand that many of these deductions are not ‘actual” deductions in business income and thus might qualify as addbacks (according to underwriting rules) to the mortgage process, serving to increase eligibility.
As an example, a rental owner may claim depreciation on the property they’re renting. That can produce a very large reduction in their rental income, often resulting in a ‘loss’ for the investment. But it’s only a loss on paper. No one writes a check out each month to pay for depreciation, at least not in the classic sense. Let’s say you have a rental that showed a $4000 loss last year but that loss was produced by a $12000 depreciation deduction (not uncommon). The depreciation amount is not money out of your pocket. The $12000 can usually be added back to your taxable income, which is significant in the mortgage qualification process.
It’s the same argument when a contractor is depreciating a $300,000 front end loader or a farmer depreciating a tractor or a Tupperware vendor depreciating their vehicle. In all of these cases, the income add-back reduces your debt-to-income ration which can qualify you for a larger loan or a lower interest rate or both.
Looking at a tax return, we often see non-taxable income which is not included in the taxable income number the mortgage broker might be looking at. For example, a foster parent might receive non-taxable government payments or someone with annuity income could have a large percentage of that income classified as non-taxable. In either of these cases, the non-taxable income is available for use by the potential home buyer but their loan eligibility might be negatively impacted if that income is not being considered in the mortgage analysis. (note that allowable add-backs can vary from lender to lender.)
So, if you’re applying for a mortgage and something about your mortgage income analysis doesn’t seem right, it might be worth a call to your tax advisor, or to us.
Rates are coming down, good luck.
Aurora Financial Services, Inc
303-745-3962
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