How to get around DTI limitations?

Question

Hi BP,

I get this question over and over again from new real estate investors that are just starting out - how do I get around DTI limitations? In order to buy more real estate by means of conventional lending, you have to significantly (and sometimes unrealistically) increase your income. Many new investors, unless they have a very high income, will face this issue after the 2nd or even 1st house they purchase (especially in more expensive areas).

What are the best ways of thinking about this issue? And what are the more common ways of bypassing these limitations? Is private lending the best way to do this or are there better/more beginner friendly ways?

Thanks!

Chris Mason · Answer

Assuming you are buying cashflow positive real estate, DTI should get better with each acquisition. Sometimes it doesn't "look" cashflow positive on tax returns, that's probably the most common thing jamming people up. Top two culprits for that are: a) advanced business entity tax strategies. Cool, you made yourself look broke, the Agency mortgage underwriter sees that too. Whoops. Solution here is DSCR loans, that comes with higher rates and fees. Hopefully the tax savings make up for it, but it's a package deal. b) Things on Schedule E of your personal tax returns that I will politely call "errors." Schedule E is where your rental property income is reported, if you don't have any fancy business entity tax strategies going on. Two tips: 1) If your CPA gives you a choice between writing off an expense as a "repair" or as "depreciation," depreciate it (if you want Agency 30YF good mortgages, that is). The underwriter will "add back" that write-off to your income, so it'll save you tax money without hurting your DTI.2) Fair rental days. CPA software defaults/auto-populates to 365, and your CPA left that default value in for whatever reason. But you purchased the property in June. So the underwriter may divide your 6 months of income by 12, and effectively cut your calculated rents in half (b/c you told the IRS you had it rented the entire year). If you only owned the property half the year, then fair rental days should be more along the lines of 30 * 6 = 180 days. The other reasons people have DTI issues either aren't real estate investor specific (such as quitting your W2 job for a 1099 gig), or are examples of "the system working as intended" (such as buying a bunch of poorly cashflowing properties).

Richard Advani · Answer

Hey Michael. Actually many lenders like myself offer DSCR loans which do not require income documentation to qualify and are based on the property cash flow. Conventional loans which we also offer are still the least expensive means of obtaining residential real estate financing. On Average this DSCR loans are about 1% higher in rate that the conventional deals. Let me know if you want further information.

Madison Wilson · Answer

Hi Michael! Great question. In terms of investors buying multiple properties, do note that rental income cannot be counted as a source income until the property has been owned and collected rent for 1-2 years, or until it is shown on the Schedule E portion of your tax returns. I would chat with your lender and see what the underwriter on the file suggests. Ultimately, it may turn into needing to lower the purchase price if income is limited.

Chris Seveney · Answer

@Michael SmythiesPersonally I do not believe it’s something that someone should work aroundThe reason for DTI is for protection to make sure someone is not over leveraged. Now there are cases where someone has $ coming in that is not counted, but in rare cases I can see a work around but in most cases you shouldn’t do a work around.

Trevor Alexander · Answer

Hi Michael - Most often from what I see is because of all the write-offs on their tax returns. There is a calculation that Lenders have to use on the individuals Schedule E, and there are some addbacks allowed with depreciation being the big one that I've seen save investors. But, for the most part...the net profit on the Schedule E is what's being looked at to determine income. If that's a loss (because they don't want to pay taxes, which of course who doesn't), then on paper then don't have any positive income from those properties, therefore have a high DTI according to the Lender. In reality, their DTI is lower, but if the taxes aren't being paid on it, we can't use it. Short answer to continue qualifying for Conventional loans...report more net profit and pay more taxes on the REO schedules. There's only one way to improve DTI on a loan application - add more income or decrease the outgoing debt. Adding income would include adding a second borrower, or increasing the net profit reported on their schedule E. Outside of that, you'd be looking at private lending or DSCR loans.

Michael Smythies · Answer

Thank you for your response Chris. I probably should have been more specific with my question. I was framing this question more so in the context of people with streams of income coming from rental properties. How is it that some investors are able to afford having dozens of rental properties? Presumably they're bypassing DTI restrictions in some capacity.