What Do Underwriters Look for on Tax Returns?

Tax returns offer a detailed financial overview. For various financial assessments, such as loan applications, these documents are frequently requested. They provide a verified record of income, expenses, and tax liabilities, showing a borrower’s financial health. This transparency allows lenders to evaluate creditworthiness and the capacity to manage financial commitments.

The Underwriter’s Goal in Reviewing Tax Returns

Underwriters examine tax returns to verify income and assess a borrower’s ability to repay a loan. This review helps determine income stability and continuity, a significant factor in risk assessment. Tax returns are a standardized, officially filed record, making them a reliable source of financial information. The information from tax returns is then used to calculate financial ratios, such as the debt-to-income (DTI) ratio.

The DTI ratio compares monthly debt payments to gross monthly income, providing insight into how much of an applicant’s income is already allocated to existing obligations. Lenders commonly prefer a DTI ratio below certain thresholds, often around 36% to 43%, though some may allow up to 50% or more depending on the loan type and other compensating factors. This calculation helps underwriters determine if a borrower has sufficient disposable income to comfortably manage new debt payments. Scrutinizing tax returns helps underwriters understand an applicant’s financial standing for informed lending decisions.

Analyzing Income Sources and Stability

Underwriters analyze various income types reported on tax returns, typically requiring two years of returns to establish consistency and stability. For W-2 income earners, underwriters verify reported wages against W-2 forms and pay stubs to ensure accuracy and consistent employment. Regular and stable W-2 income over multiple years is viewed favorably, indicating reliable repayment capacity.

For self-employed individuals or business owners, the analysis becomes more detailed, involving specific tax schedules. Income from a sole proprietorship is reported on Schedule C, while partners in partnerships and S-corporation shareholders receive Schedule K-1 forms. Underwriters scrutinize these schedules, focusing on the net income after expenses, and often add back certain non-cash expenses like depreciation to arrive at a more accurate qualifying income. Multi-year profitability and stable income trends are important for self-employed borrowers, as fluctuations can raise concerns about income reliability.

Rental income is assessed through Schedule E, where property owners report income and related expenses. Underwriters evaluate the net positive income from rental properties, considering expenses and depreciation, to determine how much of this income can be used for qualification purposes. Other income sources, such as interest and dividends reported on Schedule B, or capital gains on Schedule D, are also reviewed for their consistency and sustainability over the required two-year period. Non-recurring income, like certain bonuses or one-time gains, may not be counted towards qualifying income, as the focus is on stable and predictable earnings.

Evaluating Deductions, Credits, and Financial Obligations

Underwriters review deductions and credits on tax returns to understand their impact on a borrower’s financial picture, distinct from how they affect taxable income. While itemized or standard deductions reduce taxable income, they do not directly reduce the gross income used for loan qualification. The underwriter’s primary interest lies in the actual cash flow available to service debt, rather than just the amount subject to income tax.

Business expenses, particularly those on Schedule C for self-employed individuals, receive close attention. Certain non-cash expenses, such as depreciation, depletion, and business use of home deductions, are frequently “added back” to the net income to determine the true qualifying income for lending purposes. This adjustment is made because these expenses reduce taxable income without representing an actual outflow of cash that would impact a borrower’s ability to repay a loan. For example, a business might show a lower net profit due to significant depreciation, but the cash is still available to the owner.

Other significant deductions, like student loan or mortgage interest, and various tax credits, are also examined. While these reduce tax liability, their effect on qualifying income for loan purposes is different. Credits reduce the amount of tax owed, but they do not increase the borrower’s gross income or directly enhance their capacity to take on new debt. The presence of substantial interest deductions on a tax return can also indirectly reveal other financial obligations, signaling existing debt burdens or investment activities that influence the underwriter’s assessment of total financial commitments.

Common Red Flags and Underwriter Concerns

Underwriters watch for specific issues or patterns on tax returns that can signal potential risks and may require further explanation or impact loan approval. Significant fluctuations in income from one year to the next are a red flag, especially for self-employed individuals, as this can indicate instability in earnings. A large decline in income or inconsistent year-over-year earnings may prompt additional scrutiny or even lead to a loan denial.

Consistent business losses reported on Schedule C or K-1 can negatively affect eligibility, as they reduce the borrower’s effective income available for debt repayment. While some losses might be acceptable in specific circumstances, a pattern of continuous losses suggests a business that is not generating sufficient income. Similarly, excessive write-offs or overly aggressive deductions that substantially reduce taxable income may raise questions about the true income available for debt service. Underwriters aim to distinguish between legitimate business expenses and those that might artificially depress reported income.

Inconsistencies between the tax return and other financial documents, such as pay stubs or bank statements, raise concerns. Such discrepancies can indicate misrepresentation or errors, necessitating further investigation. Missing tax returns are a red flag, as they can suggest unfiled liabilities or an attempt to conceal financial information. Underwriters often request IRS tax transcripts using Form 4506 to verify the authenticity of submitted tax documents and ensure income is accurately represented.