Accurately reading a tax return is a skill for loan officers. These documents provide a detailed financial narrative, offering a look into a borrower’s stability and their capacity to manage and repay new debt. Understanding this narrative is part of assessing risk and making sound lending decisions, which forms the basis of responsible lending.
Key Tax Forms for Loan Analysis
A loan officer’s analysis uses a specific set of documents to understand a borrower’s financial life. For a thorough credit assessment, familiarity with these forms is required. For applicants with ownership in separate business entities, the business’s own tax returns are also required.
- Form 1040 (U.S. Individual Income Tax Return): Summarizes income from all sources for an individual.
- Schedule C (Profit or Loss from Business): Attached to the 1040, it details the revenues and expenses of a sole proprietorship.
- Schedule E (Supplemental Income and Loss): Also attached to the 1040, it reports income from rental properties, royalties, partnerships, and S corporations.
- Form 1120 (U.S. Corporation Income Tax Return): Filed by C Corporations.
- Form 1120-S (U.S. Income Tax Return for an S Corporation): Used for S Corporations.
- Form 1065 (U.S. Return of Partnership Income): Filed by partnerships.
- Form K-1: Reports each owner’s share of income, deductions, and credits from an S Corp or partnership, linking the business’s performance to the individual’s 1040.
Analyzing Personal Tax Returns
The analysis of personal tax returns starts with Form 1040. For many applicants, the wages and salaries line corresponds to the income reported on their W-2 forms. A loan officer will match this number to the applicant’s provided pay stubs and W-2s to confirm its accuracy.
For self-employed borrowers, the focus shifts to Schedule C. The analysis begins with the gross receipts or sales line. From this top-line number, the various business expenses listed are subtracted to arrive at the net profit or loss. This net figure is considered the borrower’s income from the business before adjustments.
Rental income is detailed on Part I of Schedule E. Loan officers examine the total rents received and then deduct the expenses associated with the properties, such as mortgage interest, property taxes, and operating costs. The resulting net rental income or loss gives a view of the profitability of the borrower’s real estate investments.
Part II of Schedule E reports income or loss passed through from a partnership or an S corporation. This number is a summary. To verify this income, a loan officer must obtain the corresponding Schedule K-1 for each entity listed, which breaks down the specific amounts being passed through.
Analyzing Business Tax Returns
Evaluating a business’s tax return focuses on the health and profitability of the entity itself. This financial performance directly impacts the income available to the business owners. The type of business structure determines which form is filed and how the income is reported.
For a C Corporation filing Form 1120, income is taxed at the corporate level before profits are distributed to shareholders as dividends. A line item to check is the taxable income before any net operating loss (NOL) deduction and special deductions. This figure provides a measure of the company’s operational profitability before certain tax-specific adjustments.
An S Corporation, filing Form 1120-S, is a pass-through entity where profits and losses are passed directly to the shareholders’ personal returns. The primary figure on this return is the Ordinary Business Income (or Loss). This amount represents the net profit from the company’s primary operations and flows through to the individual owners via the Schedule K-1.
A partnership filing Form 1065 also functions as a pass-through entity. The focus is on the Ordinary Business Income (or Loss) reported on the first page. This net income is then allocated to the individual partners according to their ownership stake, as detailed on their respective K-1s.
Identifying Income Add-Backs and Non-Recurring Items
An important step in tax return analysis is adjusting the reported taxable income to determine the borrower’s cash flow. Taxable income is often reduced by non-cash expenses, which are accounting deductions that do not represent an actual outflow of money. Adding these expenses back to the net income provides a more accurate picture of the cash available to service debt.
Common add-backs are depreciation and amortization. Depreciation is the expense for the wear and tear on physical assets, while amortization is for intangible assets. These deductions are found on a dedicated line on business tax returns and schedules like Schedule C and Form 1120-S.
It is also necessary to identify and subtract any one-time or non-recurring income that may inflate a borrower’s earnings for a single year. A large capital gain from the sale of an asset, for example, is not a reliable source of future income. Removing such items ensures the qualifying income is based on stable, repeatable earnings for a realistic assessment of repayment ability.
Calculating Final Qualifying Income
The final step is to synthesize all the gathered information into a single qualifying income figure. This process provides a standardized method for evaluating different types of income.
The calculation begins with the net income from the relevant tax schedule, like the net profit from Schedule C or the ordinary business income from Form 1120-S. To this base number, add back the non-cash expenses identified earlier, such as depreciation and amortization. This adjusted figure represents the available cash flow.
For business owners, it is necessary to confirm that this calculated cash flow is accessible to them personally. This involves verifying the owner’s salary or distributions from the company, which can be found on W-2s or the Schedule K-1. To account for fluctuations, it is standard practice to average the qualifying income over the most recent two years for self-employed individuals and business owners.
Common Red Flags in Tax Returns
Tax returns can reveal warning signs that suggest potential risk. Identifying these red flags is part of a loan officer’s due diligence and can prompt further questions and a more cautious approach to the lending decision. A loan officer should investigate the source of any of the following:
- A pattern of declining revenues year-over-year, which could indicate a struggling business.
- A large, unexplained jump in income in the most recent year, as it may not be sustainable.
- A significant increase in liabilities on a business’s balance sheet, which could signal growing debt.
- Inconsistencies between personal and business tax returns, such as K-1 income not appearing on the personal 1040.
- The presence of an amended return (Form 1040-X) or unusually high business expenses relative to revenue.