The more deductions you claim, the less a bank will lend to you?

Question

Would it necessarily be true that the more deductions you claim on your tax return the less a bank will lend to you because of your lower taxable income?

So therefore, isn't this technically a catch 22 situation where you would like to claim more deductions but technically shouldn't if you would like to buy a property in the future because the bank will lend you less money because of the reduction in your taxable income?

J Scott · Answer

While it sounds like Rich is using the terms "expenses" and "deductions" incorrectly, I think the point he is trying to get across is that there are certain expenses that can be written off in the context of running a business that can't be written off without the pretense of a business.

For example, certain vehicle expenses are deductible if the vehicle is used for business purposes.  Certain home ownership expenses are deductible if you have a home office that you use for a business.  Etc.

The key is that you actually have to RUN the business to get these deductions.  If the business is just a shell to deduct expenses that otherwise wouldn't be deductible, you're going to get in trouble with the IRS.

Creating a shell business to "convert expenses to deductions" (as Rich calls it), it not advisable, in my opinion...but creating a REAL business to do this is a great idea, if you have the time, energy and skill.

Rich Weese · Answer

I disagree with most of this thread. The only part I agreed with was the 2nd paragraph by Finance. He hit the magical key- depreciation.
    I learned very early in business(due to an IRS audit) that there are 2 ways to minimize taxes.
1. Have a business or 2nd business to convert EXPENSES into DEDUCTIONS.
2. Own real estate (lots of realestate!!)

I'm currently with a mortgage company getting prequalified for a new residence since I'm moving.

Actually, I am telling the IRS one thing and the lender a different thing. All with the same documents. Basically tax returns. TO the IRS, I don't show much net income.
   
However, the mortgage company looks at the same docs and sees something different. They do see income and ability to make payments on their loan.

Most  all of this is due to the magic of depreciation. The IRS looks at that as offsetting expense(right or wrong, loophole or not) and I declare a lot of it to eliminate hundreds of thousands of dollars in "taxable income". The mortgage company takes my returns directly to their underwriter, adds certain paper losses back in, and determines a loan amount.
  
Joel- My tax return does show hundreds of thousands of income, but it also shows a like amount in DEDUCTIONS. Therefore I don't pay 10's of thousands in taxes.
I'm also not waiting for liars' loans to return. All the info is there to accomplish this.

As Judge Learned Hand said in a famous IRS court decision- It is to right of a person to organize his affairs in a manner to MINIMIZE the amount of taxes owed. (I badly paraphrased that statement, but you can find it out there if you look)

This is what I've done through 40+ years of filing tax returns.  I dedicated a chapter in my book to "the worst partner you'll ever have"  (IRS) and I'll never change that attitude. They are crooks and I'm proud to have beaten them in both audits I've had, legally.
     Now disclaimer-I'm not an acct and offer no advice, just facts. Consult a licensed CPA before you try this at home...Rich

David Beard · Answer

The 25% deduction that banks will take from gross income is normally intended to cover vacancies and all expenses other than taxes and insurance.  If taxes and insurance run 15% of gross potential rent (typical), then you're at 40% expenses prior to replacement reserves of 5-10%.  So this lines out fairly well with the 50% rule.

However, if you have tax return history on the property, then the bank of course want to use your tax returns.  In theory, they can adjust for anomolous items such as high repair expenses in a given year, but I don't know if anyone is successful with this anymore.  They want everything cut and dried, so that down the road if you default and FNMA is looking through the file for defects so that they can make the originator buy it back, then the bank doesn't have subjective crap in the file that they can't support.

Obviously some things, like certain repairs, can be alternatively capitalized and depreciated over time.  That stings you from a time value standpoint on your taxes but does allow you to report higher current income.  There is a tradeoff between the time value of the current deduction and the tremendous potential ROI benefit of being able to obtain financing.

Doing projections of your future debt ratios and other aspects of your "lending profile" is critical, and can potentially help guide you in how aggressive you want to be in taking deductions.

Even local banks lending for their portfolio are under some of the same pressure to be cautious with subjective underwriting adjustments due to regulatory oversight/review of their loan portfolios, though local banks can definitely be much more flexible than secondary market originators.

I'd be curious if anyone has had luck with getting tax return adjustments accepted by their lender, and what you did to prove your case.  (I'm not talking about depreciation, that's an automatic add-back).  High repair expense and high vacancies would be the areas where you could try to prove it was a one-off event.

It's a good topic. I've talked to several self employed people who are locked out of the lending market now, are trying to build their tax-return income, and are banging their heads because they can't take advantage of the real estate bargains that are out there.  Of course, in those cases where they were simply under-reporting their income, I'm not sympathetic.

Account Closed · Answer

This is a very common situation for many tax payers. Mortgage companies want to know that you have the income to support a loan.  The IRS will tax you based on income.

Obviously there are differences between the income used by a lender and the income used by the IRS.  Depreciation, amortization, nontaxable income, and a few other things.

Utilizing more depreciation for your rental properties can improve your ability to lower both your taxes and raise your chances of getting a loan.

I do advice many of my clients to get involved in a new business.  This can be a great way to lower taxes,  but it does need to be a legitimate business activity rather than a hobby.

As you earn more it is necessary to do some tax planning and look at what it is you want to accomplish.  It is good to have a clear idea of your priorities and what you want to accomplish.

Zachary Dosch · Answer

This is where working with a good lender and bank is very important. You are most likely not going to have a lot of luck getting a mortgage from the big mortgage companies with out showing the necessary taxable income. If you know you are going to be purchasing a new home, you might want to save some of the expenses for the next year to show an increased amount of taxable income.

However, if we are talking about business loans, you can absolutely add back in at least all the depreciation. Commercial loan underwritting is a lot more logical and the loan structures are much more sound.

Personal mortgage underwritting is sloppy. Any company willing to lock in rates at 3.625% for 30 years is insane. No wonder the housing market crashed. Its a little better now than pre crash but not much. What's going to happen to all these companies when the rates go back up to 6%?

Sheila Allen · Answer

It is my recent experience that all depreciation is no longer added back.  I have $110,000 in loss on my Sch F (Farm Income) so it reduces my net income considerably.  Therefore, I have been denied a refinance of my ranch in Texas.  Adding this back makes it a no-brainer.  Any ideas?  Lenders (two of them) say to thank Frank Dodd.  I don't know who to thank but want to refinance while rates are low!

Rich Weese · Answer

Update to thread- Well, we're officially in Utah now. It took 4 trucks to get us here! Two autohalers, 1 moving van and our pickup pulling a cargo trailer-2500 miles.Anyway, a couple updates and corrections.

taxable income was 13,618
tax- 1363
self employment- 413
making work pay credit- (420)
total tax 1385

To the IRS, I made $13,618 for the year. To the lender, (using same tax returns) I qualified for a $299,000 newly constructed 26oo sq. ft. home.

The keys were several to qualify
1. LOADS of usable depreciation to offset income( all know this)
2.Income showing up on installment sales, where IRS only taxes a %, yet lender counts ALL of it. (Charles- did I explain this correctly?)
3.Capital gain/loss totals.

Charles- I agree it has to be a legitamate business. As I've posted before- take a hobby and turn it into an ACTUAL business. Now, you are able to change normal expenses you have into taxable deductions (computer, auto, mileage etc)Many if not all hobbies can be turned into a LEGITIMATE business , if done correctly. Needs to eventually make money or you need to find a new hobby/business.

Jeffrey-disclaimer!!! I'm not an accountant. I chose to sell several properties on an installment sale, rather than taking all the cash on sale. I "believe" on an installment sale, you ONLY pay a % of money collected each year. You show ALL the income on return, but using the proper form,only a portion transfers to the income portion of your return. That is about as clear as I can explain it.Rich

Bill Gulley · Answer

Read my first post and save yourself some trouble, move on, at least to the question posed by the OP.

Bryan, not even worthy of comment, ridiculous comparison

Jeffrey Magenes · Answer

Could you clarify a bit more regarding this? What installment payments are you referring to? I'm a bit lost. Thanks,.

Rich Weese · Answer

OK. A followup to my LONG post earlier today. I just received loan approval for a loan on a personal residence. They did take my Installment payments excess into consideration. The approval, in spite of showing taxable income of $14,300 total. To the IRS, I owe them $1400 but to the lender I look good. You really can have your cake and eat it too. Rich

The more deductions you claim, the less a bank will lend to you?

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