Tax Return Income Analysis Broker Essentials Broker Essentials

Residential Broker Lending Essentials Training Participant s Workbook TRIA.1 August, 2009

This booklet is designed to assist Brokers to determine self employed income using the applicant s Tax Returns and the Union Bank 1040 Individual Tax Analysis form. When are Tax Returns Required by Union Bank? Tax Returns are required when an applicant fits one of the following scenarios: Applicant owns 25% or more of a business. The business can be a Sole Proprietorship, Partnership (General or Limited), Corporation, S Corporation or Limited Liability Company (LLC). Applicant derives 25% or more annual income from commissions. Applicant derives 25% or more annual income from bonuses. Applicant derives 25% or more annual income from overtime. Applicant employed by a relative. May be required when Applicant is retired. May be required when Applicant receives rental income. 2. TRIA Participant s Workbook

How Long Must the Self-Employed Applicant be Self Employed? The applicant must be self employed in their business for a minimum of 2 consecutive years. Which Tax Return Forms are Required? To underwrite the self-employed applicant, the following federal Tax Returns are required: Copies of signed individual Tax Returns (1040s) and all applicable schedules (Schedules A and B, C, D, E, F) and statements for the most recent two years Copies of signed business Tax Returns (K-1s, 1065s, 1120Ss, 1120s) and all applicable schedules and statements for the most recent two years A signed year-to-date (YTD) Profit and Loss Statement (P&L), if the loan application is dated more than 120 days after the end of the business tax year Note: State Tax Returns are never required and should never be sent to Union Bank. To Confirm Tax Return Validity Form 4506-T (signed by the applicants) is required for each applicable tax form (i.e. 1040, 1065, 1120S, 1120). If the Underwriter questions the validity of the submitted Tax Return(s), the 4506-T is executed (sent to the IRS, who then responds with the requested year tax transcripts). Participant s Workbook TRIA.3

Union Bank 1040 Individual Tax Because self-employed income changes from year to year, an average better approximates the applicant s long-term earning ability. The Union Bank 1040 Individual Tax Analysis form is designed to determine the qualifying income and then calculate an average monthly income. The Underwriter determines if income is acceptable to be used when determining the qualifying income. Projected or future income is not acceptable for qualifying purposes. As a trend, annual earnings that are level or increasing are acceptable. A continuing large decline in gross income over two or three years is viewed cautiously; even if the applicant s current income and debt ratios meet guidelines. If the income is declining, this may be a reason to decline the loan; however, the Underwriter considers income source and evaluates the individual business to estimate potential for long-term earnings. If the applicant s income has decreased in the most recent year, the average of the most recent years income is generally used as the yearly income for qualifying purposes. For large increases in income, the Underwriter determines if the increase is continuing or a one-time occurrence. If the applicant s income has increased in the most recent year, the average of the two years income is used as the yearly income for qualifying purposes. Any large fluctuations up or down must be addressed with a signed letter of explanation from the applicant. 4. TRIA Participant s Workbook

Participant s Workbook TRIA.5

Completing the Union Bank 1040 Individual Tax Use the instructions in the following pages to populate the Union Bank 1040 Individual Tax Analysis form. Note: If the Tax Returns are joint returns and only one of the taxpayers is the applicant, the Underwriter makes a determination if 100% of the income can be used. Line 1.) Adjusted Gross Income: Review 1040, Line 37 (Adjusted gross income) Enter the amount from Line 37 of the 1040 (Adjusted Gross Income) to line #1 of the Analysis form. From this point, you add or subtract earning and expenses as indicated on the form. Note: The Tax Return forms change from year to year. Line numbers referred to in this booklet may change (i.e. in 2009 the Adjusted Gross Income may be on line 38). Line 2.) Wages, salary considered elsewhere (or nonrecurring): Review 1040, Line 7 (Wages, salaries, tips, etc.) If the wages are from the applicant s own business and the income is stable and consistent, do not subtract the wages. If the wages are from a source other than the applicant s self-employment (i.e. spouse s wages, wages from a previous job, etc.) subtract them from the total income and consider this income separately. Inclusion of these earnings will most likely provide a lower average. 6. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Line 3.) Tax Exempt Interest Income: Review 1040, Line 8b (Tax-exempt interest) Tax-exempt interest is generally received on investments in state and municipal bonds. The source of this income must be documented if it is used to qualify the applicant and must have been received for at least 2 years and probability of continuation must be supported (i.e. with Bank Statements, etc.) in order to use this income for qualifying purposes. Add tax-exempt interest income received to the cash flow, if it is verified as recurring income and the source will not be used for the subject transaction. Note: The non-taxable amount is grossed up 22% on Line 24 of the Analysis form. Note: Any amount listed on Line 8a (if over $400) and Line 8b of the 1040 should be itemized on Schedule B. 8. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Line 4.) Tax Exempt Dividend Income: Review 1040, Schedule B, Part II (Ordinary Dividends) The dividends listed on the 1040 are usually from stock and mutual funds. Occasionally dividends are tax-exempt and are listed (normally at the bottom) on Part II of Schedule B. They show as tax-exempt and are deducted from the total of dividends. Add tax-exempt dividend income received to the cash flow, if it is verified as recurring income and the source will not be used for the subject transaction. The source of this income must be documented if it is used to qualify the applicant. Note: The non-taxable amount is grossed up 22% on Line 24 of the Analysis form. 10. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Line 5.) Taxable Refunds: Review 1040, Line 10 (Taxable refunds, credits, or offsets of state and local income taxes) A refund is non-recurring and is subtracted from the cash flow. 12. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Schedule C Schedule C : Review 1040, Schedule C (Profit or Loss from Business) The net profit or loss from the Business on line 31 of the Schedule C has been brought forward to line 12 of the 1040. We analyze four expenses from Schedule C. Line 6.) a. Depreciation/Depletion Review Schedule C, Lines 12 (Depletion) and Line 13 (Depreciation) Depreciation is the loss of value of a tangible asset due to wear and tear. Tangible assets are items such as real estate, machinery, trucks, vans and office equipment. Depletion is the loss of value to a natural resource, such as an oil field or mining rights. Depletion and depreciation are accounting methods that allow a business to deduct a certain amount annually so the business can "save" to replace an asset that is losing value or wearing out. While the business doesn't actually make an expenditure, it is allowed to deduct the amount in the form of an expense. This expense is used to reduce the taxable net profit. Both Depletion and Depreciation are considered non-cash expenses or paper write-offs and are added back to the cash flow. 14. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Schedule C, cont. Line 7.) b. Amortization Schedule C, Page 2, Part V (Other Expenses) Total of Other Expenses then brought forward to Schedule C, Page 1, line 27. Amortization is the loss of value to an intangible asset. Intangible assets are items such as start up costs, copyrights, trademarks, licenses and patents. Amortization is considered a non-cash expense or paper write-off and is added back to the cash flow. 16. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Schedule C, cont. Line 8.) c. In home office use Review Schedule C, Line 30 (Expenses for business use of your home). Amount was calculated on Form 8829 and said form should be attached. Because the applicant has expenses for their home regardless of using a portion of the home for their business, this amount is added back to the cash flow. Line 9.) d. 50% meals and entertainment Review Schedule C, Line 24b The IRS restricts the amount a business is allowed to deduct as meals and entertainment expenses. Currently, a business may deduct only 50% of the total expenditures in this category. Because the business actually spent the entire amount for meals and entertainment, we subtract the remaining 50% from the applicant's income to get a true picture of the bottom line cash flow. Therefore, the entire amount on this line is subtracted from the cash flow. 18. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Schedule D Schedule D : Review 1040, Schedule D (Capital Gains and Losses) The net gain from Capital gains on line 16 of the Schedule D is brought forward to line 13 of the 1040. The net loss from Capital gains on line 21 of the Schedule D is brought forward to line 13 of the 1040 up to a maximum loss of $3,000. Losses greater than $3,000 are usually carried forward to the next tax year. Capital gains or losses are generated from real estate or stocks that were sold during that tax year. For underwriting purposes, it makes no difference if the asset is a short-term or long term gain/loss. It's the total gain or loss that is considered. Secondary market investors consider capital gains or losses as non-recurring because taxpayers generally have gains some years and losses in others. As a general rule, "neutralize" the gain/loss by subtracting gains and adding back losses. If a consistent 3 year history of gains is documented (3 years 1040s show gains with no losses) and probability of continuing gains can be supported, then the Underwriter may consider these gains as income. Line 10.) a. Recurring loss adjustment: Review Schedule D, Line 16 If there is a loss that is recurring, it is important to note that the IRS may only allow a portion of this loss to be claimed. The difference between the claimed loss (1040, Line 13) and the actual loss (Schedule D, Line 16) is subtracted from the cash flow. 20. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Schedule D, cont. Line 11.) b. Non-recurring loss: Review 1040, Line 13 In most cases, a capital loss (limited to $3,000) is a nonrecurring event; therefore, the entire dollar amount on this line is added. This neutralizes this loss as if it never existed. Line 12.) c. Non-recurring gain: Review 1040, Line 13 In most cases, a capital gain is a non-recurring event; therefore, the entire dollar amount on this line must be subtracted. This neutralizes this gain as if it never existed. 22. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Schedule E Schedule E : Review 1040, Schedule E (Supplemental Income and Loss) The net profit or loss from rental real estate, royalties, partnerships, S corporations, estates and trusts on the Schedule E has been brought forward to line 17 of the 1040. Line 13.) or 14.) Neutralize Income or Loss: Review 1040, Line 17 Income on Schedule E often has the greatest difference between that which is taxable, and that which we can use for the applicant s cash flow. For this reason, the first step is to neutralize the taxable amount claimed on Line 17 of the 1040 as if it never existed. By adding back the loss or subtracting the gain we begin with a clean slate. Input the gain or loss from Line 17 on the appropriate line, 13 or 14, of the Analysis form. 24. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Schedule E, cont. Line 15.) a. Rents/Royalties received: Review Schedule E, Lines 3 and 4 Verify real estate listed on Schedule E against the 1003 application. Schedule E will match unless rental properties were recently purchased or sold. If the rental property was recently sold, a copy of the HUD-1 is required and do not include the rent from Schedule E. If the rental property was recently purchased, obtain a copy of rental agreement and use 75% of the gross rent. Combine the rents from Line 3 and the royalties from line 4 and input on the Analysis form. Note: If the subject property is a rental, do not include this income as it will be considered separately using the appraisal information. Note: If the applicant s principal residence is converting to an investment property up to 80% of the rental income can be used if there is documented equity of at least 30% in the existing property, derived from a current appraisal or a broker price opinion. Six months reserves are required. Line 16.) b. Expenses (exclude depreciation) Review Schedule E, Line 19 Because the applicant has expenses in connection with rental properties we subtract this figure from the cash flow. Input the total of expenses from Line 19 on the Analysis form. Note: Depreciation is not added back on the Analysis form because we began with a clean slate for Schedule E. 26. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Schedule E, cont. Line 17.) c. All Partnership & S-Corp Income Review the applicable K-1 s Our applicant s share of the business income or loss is shown on the K-1 schedule (Shareholder or Partner s Share of Income, Credits, Deductions, etc.). The K-1 is a schedule from the business return (1065 or 1120S). The K-1 will provide most of the information needed. It discloses the percentage of ownership (K-1, 1065 on Line J and K-1, 1120S on Line F). The K-1 also has the net cash flow brought forward from the business return (1065, Line 22 or 1120S, Line 21) (i.e. if the applicant has 50% interest in the partnership and the total income from the 1065 is $100,000, the K-1 will show income of $50,000 or 50% of the total). On Line 17 of the Analysis input the ordinary income from the K-1, Line 1, the net income from rental real estate activities from the K-1, Line 2 and net income from other rental activities figures from the K-1, Line 3. Do NOT use the figure on page 2 of Schedule E as it may include previous year s losses and not reflect the true cash flow. If the applicant is a General Partner, and guaranteed payments are recurring, as indicated on the current and past K-1, line 4, the guaranteed income is included. Line 18.) d. General Partnership & S-Corp loss (Passive and non-passive) On Line 18 of the Analysis input the ordinary loss from the K-1, Line 1, the net loss from rental real estate activities from the K-1, Line 2 and net loss from other rental activities figures from the K-1, Line 3. Do NOT use the figure on page 2 of Schedule E as it may include previous year s losses and not reflect the true cash flow. 28. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Schedule E, cont. Line 19.) e. General Partnership & S-Corp: Depreciation/Depletion/Amortization Partnership: Provided the applicant is a General Partner, review 1065, Line 16a for Depreciation. Review Line 17 for Depletion. Review Line 20 Other Deductions as this includes the Amortization. Find the Other Deductions attachment to determine the Amortization figure, if any. If the applicant is a Limited Partner, do not add back the depreciation, depletion or amortization. S Corporation: Review 1120S, Line 14 for Depreciation. Review Line 15 for Depletion. Review Line 20 Other Deductions as this includes the Amortization. Find the Other Deductions attachment to determine the Amortization figure, if any. Remember, depreciation is the loss of value of a tangible asset due to wear and tear. Depletion is the loss of value to a natural resource. Amortization is the loss of value to an intangible asset. Depletion, Depreciation and Amortization are considered non-cash expenses or paper write-offs and are added back to the cash flow. IMPORTANT: Calculate the depreciation/depletion/ amortization according to the percentage of ownership the applicant has in the Partnership and/or S Corporation. 30. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Schedule E, cont. Line 20.) e. General Partnership & S-Corp: Mortgages, Notes, Bonds payable in less than 1 year Partnership: Provided the applicant is a General Partner, review 1065, Schedule L, Line 16, column d. If the applicant is a Limited Partner, do not subtract the Mortgages, Notes, Bonds payable in less than 1 year. S Corporation: Review 1120S, Schedule L, Line 17, column d. This is an expense to the applicant s business cash flow. IMPORTANT: Calculate the mortgages/notes/bonds according to the percentage of ownership the applicant has in the Partnership and/or S Corporation. 32. TRIA Participant s Workbook

Form 1120S page 4 Form 1065 page 5 Participant s Workbook TRIA.33

Completing the 1040 Individual Tax, cont. Schedule F Line 21.) Schedule F, Depreciation: Review 1040, Schedule F (Profit or Loss from Farming) The net profit or loss from farming on the Schedule F has been brought forward to line 18 of the 1040. Depreciation on Line 16 is added back to the cash flow. Depletion is considered a non-cash expense or paper write-off and is added back to the cash flow. 34. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Line 22.) Non-Tax Portion Social Security: Review 1040, Line 20 (Social security benefits) The non-taxable amount of the applicant s social security benefits are added back to the cash flow. To determine the non-taxable amount, subtract Line 20b (taxable amount) from line 20a (total social security benefits). Note: The non-taxable amount is grossed up 22% on Line 24 of the Analysis form. Line 23.) Non-Tax Portion Recurring Pension/Annuity: Review 1040, Line 16 (Total pensions and annuities) Only if the distribution is determined to be recurring may the non-taxable amount be added back to the applicant s cash flow. Supporting documentation is obtained (e.g. pension award letter) to determine the consistent/recurring receipt of the income. To determine the non-taxable amount, subtract Line 16b (taxable amount) from line 16a (total pensions and annuities). Note: The non-taxable amount is grossed up 22% on Line 24 of the Analysis form. 36. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Line 24.) 22% Gross up of non-taxable income: If you have input a figure on any of the Tax Exempt lines, you may gross-up these figures 22%: Line 3 Tax Exempt Interest Income Line 4 Tax Exempt Dividend Income Line 22 Non-Tax Portion Social Security or Line 23 Non-Tax Portion Recurring Pension/Annuity, Multiply the total of these amounts by 22% and input this calculation on the Analysis form, Line 24. If you are using the electronic Analysis form, the gross-up figure is calculated automatically. 38. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Line 25.) Non-Recurring or unverified income Review 1040, Line 15 (Total IRA distributions) If the IRA or Pension distribution is a one-time occurrence, the taxable amount is subtracted from the cash flow. Any other non-recurring or unverified income is subtracted here. Line 26.) IRA/Keough Contribution: Review 1040, Line 32 (IRA deduction) and line 28 (Self- Employed SEP, SIMPLE and Qualified Plans) Any contribution to an IRA/Keough account is added back to the cash flow. Line 27.) ½ Self-employment Tax: Review 1040, Line 27 (Self-employment tax) This is an actual expense but it is added back to show gross income. Any tax for self-employment is added back to the cash flow. Line 28.) Self-employment Health Insurance: Review 1040, Line 29 (Self-employed health insurance deduction) This is an actual expense but it is added back to show gross income. Any expense for self-employment health insurance is added back to the cash flow. 40. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. 2106 Unreimbursed Expense Line 29.) 2106 Unreimbursed Expenses: Review Schedule A, Line 21 and 1040, Line 24. If figures exist on either line look for Form 2106 (Employee Business Expenses) The expenses on Form 2106 have been brought forward to line 21 of Schedule A or line 24 of the 1040. Form 2106 is used to report reimbursed and unreimbursed expenses by a non-self-employed applicant. Examples of typical expenses may include vehicle, travel, meals and entertainment. (Often used by commissioned applicants.) Subtract the expenses from Line 10 of the 2106 from the cash flow. 42. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. 2106 Unreimbursed Expense, cont. Line 30.) 2106 Depreciation: Review Form 2106 (Employee Business Expenses), Line 28 Add the depreciation amount from Line 28 of the 2106 to the cash flow. Line 31.) 2106 50% meal/entertainment: Review Form 2106 (Employee Business Expenses), Line 9 Subtract the expenses from Line 9, Column B of the 2106 from the cash flow. 44. TRIA Participant s Workbook

Form 2106 page 2 Participant s Workbook TRIA.45

Completing the 1040 Individual Tax, cont. Line 32.) Loss Carryover: Review 1040, Line 21(Other income) If the applicant had a business loss at some point in the past, the IRS allows a deduction of a portion of the expense each year until it is all accounted for. Because the loss did not actually happen in that year add this loss back to the cash flow for that year; however, the loss carryover is subtracted from the year that it actually occurred if analyzing that year s income (use lines 37-40 of the Analysis form). Lines 33. 36.) Other Income to be Added: Student Loans: Review 1040, Line 33 (Student Loan Interest Deduction) Because Student Loan payments are included in the applicant s liabilities, the student loan interest is added back to the cash flow. Alimony: Review 1040, Line 31a (Alimony paid) Because Alimony payments are included in the applicant s liabilities, the alimony paid is added back to the cash flow. Any other expense that is non-recurring, such as moving expenses, are added back into the cash flow. 46. TRIA Participant s Workbook

Completing the 1040 Individual Tax, cont. Lines 37. 40.) Other Income to be Subtracted: Alimony: Review 1040, Line 11(Alimony received) If alimony will continue no adjustment is necessary. If less than three years remain, the alimony received is subtracted from the cash flow. Any other income which is non-recurring, such as gambling winnings, is subtracted from the cash flow. 48. TRIA Participant s Workbook

Computing the Monthly Average With the Union Bank 1040 Individual Tax Analysis form populated, compute the qualifying monthly average income by totaling the columns for both years. Add both years totals and divide that sum by 24 months to obtain the average monthly income. If the most recent year income has declined, the Underwriter may use a 12 month average of that most recent, lower income year, resulting in a lower qualifying monthly average. If using the form electronically, it calculates the most recent year s income in the 12 month average box. Questions Contact your Regional Manager, their Assistant or the Help Desk: Mid-State Region: Jennifer Livingston Regional Manager 213-972-5355 Wesley Uyema Wholesale Asst 213-972-5351 Northern Region: Susan McLaughlin Regional Manager 916-978-4787 Laura Wicklman Wholesale Asst 916-978-4783 San Diego Region Gary Wong Regional Manager 858-496-6800 Angela Liedike Wholesale Asst 858-503-4146 Southern Region Kristel Namimatsu Regional Manager 949-369-9509 Sheli Breen Wholesale Asst 949-369-9485 Help Desk Mark Minas Pam Cogan 858-503-4156 50. TRIA Participant s Workbook