In our last installment, we talked about what debts lenders count towards your debt service coverage ratio or your debt to income ratio. In this article, we’ll look at the other side of the equation, your income.
W2 INCOME: This income is pretty straight forward. You get up, go to work for a business, collect your paycheck, and go home. After the year ends toward the end of January of the following year, you receive a W2 form in the mail from your employer showing what you made in the previous year. If you are not in business for yourself and you only earn income that is stated in that W2, then you income is pretty easy to figure out. Banks look at your Gross Income for the purposes of a debt to income ratio. The acceptable percentages that they use in their calculation ignore taxes and other expenses. They just need your gross income. If you only have income from a W2, the income calculation is pretty self-explanatory.
1099 INCOME: If you are an independent contractor or a gig worker, you have undoubtedly received a 1099 from the entity or entities that you performed work for. We’ll talk about where the 1099 information goes in bit, but contractors that receive a 1099 don’t normally have taxes deducted. You technically aren’t an employee…you are in business for yourself.
SOLE PROPRIETOR AND YOUR SCHEDULE C: If you have a small business for yourself, you can typically choose to file your taxes in one of two ways. If you create a business entity, like an LLC, you will file a separate tax return for your business. That usually will be a 1120 form of some sort. Unless you elect to file a C-Corp, which very few people do, your business won’t directly pay taxes. Instead, the bottom line income will be distributed to each of the business owners in proportion to their ownership interests. Most people with a small business are the sole owner. If they don’t create an entity and they are paid in their personal name, they are normally called “Sole Proprietors”. The income that they file is entered on the Schedule C of their personal tax returns. They are then allowed to take legitimate expenses such as mileage, phone expense, and internet expense. That net figure then transfers over to the first couple of pages of the return to figure into the person’s net income.
INCOME ON THE SCHEDULE E – RENTAL PROPERTIES: The Schedule E on a tax return serves many purposes. If you are a real estate investor, there is a good chance that you will own a rental property or two. The Schedule E is where you will claim your income and expenses related to the property or properties.
INCOME ON THE SCHEDULE E – OTHER BUSINESS ENTITIES: The Schedule E also is where income from other businesses that one might own transfer through to the personal tax return. LLCs and other business entities provide the individual or corporate owner with a form K-1 that shows the owner’s share of the business income from that particular entity. The information from the K-1 is entered on the Schedule E to flow the income through to the owner’s personal tax returns.
CHILD SUPPORT, ALIMONY, AND SEPARATE MAINTENANCE INCOME: When we talked about expenses, I told you that you had to report any child support, alimony, or separate maintenance income. The income side, however, is different. You do NOT have to report any child support, alimony, or separate maintenance income if you don’t wish to do so. It normally can be counted for you, but you are not required to do so by law.
ADD BACKS: When lenders determine your overall, or global, cash flow, they are trying to get a true picture of what is coming in with respect to your revenue. There are a few scenarios where you show expenses that are only expenses on paper. The first such expense is Depreciation. Physical items, such as real estate and automobiles, show wear and tear over time. You are allowed to take an expense allowance for this wear and tear. That expense is depreciation. Amortization is similar to depreciation in that you are writing down the value of an asset over time, but amortization refers to an intangible, not physical asset. For instance, you might have a license that has value but it is good for only a certain period of time. The right down for that license is called amortization. Depletion is very much like depreciation and amortization, but it usually refers to a resource of some type. Let’s say that you have several acres with many trees on it. You decide to sell the trees for lumber, but doing so reduces the value of the property. That is depletion. Lenders will normally add back in the expense taken for depreciation, amortization, and depletion as those were simply paper expenses and not expenses that you actually paid. A very different add back is taken with respect to interest expense. When you pay for a loan, you are normally allowed to write off the interest paid as an expense. Unlike depreciation, you actually made the payments that included interest. Why is it then can you add interest expense back into the income calculation? That’s because you don’t want to be double-hit for the payment. Remember, that loan payment is being charged against you on the debt side of the DTI or DSCR calculation. In an effort not to double count the interest you paid, you are allowed to add back the interest expense to the income side of the cash flow as you are taking a charge for it on the debt side.
When I as a banker would calculate your income, I would normally start with the Adjusted Gross Income (your AGI) from your personal return, then I would immediately flip back to your Schedule E to see if you had any rental properties or other businesses that I didn’t know about. I would ask you to provide me with your business tax returns for each of the entities that you showed on your Schedule E. In those returns, I was looking for two main things. First, I am looking for interest expense, depreciation, amortization, or depletion expense that I can add back into your income. I am also looking to make sure that the amount of loan balances and interest expense that you show on those returns match the debts that you reported. I often find evidence of debts on those returns that you didn’t report. I then I add back any items that are showing for rental properties on the Schedule E. I also flip to see if you are claiming any income and expenses on a Schedule C on the personal return. Although there is more that a bank does when calculating income, in a nutshell, that is how it will work for most borrowers.
Understanding how a lender should be calculating your income when you go in for a loan is very important. Many lenders make mistakes to your detriment when they are calculating income. Knowing how it should be done will allow you to set them straight.