After you complete a mortgage application, you must provide the lender with proof of your income. Generally, this means the pay stubs for the last 30 days and your last 2 years’ of W-2s. Sometimes, however, it means your tax returns.
Who has to supply tax returns and why? While not all borrowers have to supply their tax returns, many do. Some lenders just ask all borrowers to supply them. We explore the reasons that you may need to supply your tax paperwork below.
Who Needs to Supply Tax Returns?
If your income isn’t straight forward or doesn’t come from a third-party, expect to provide your tax returns. The most common situations include:
- Self-employed borrowers
- Borrowers that earn commission
- Borrowers that have real estate investments that need the income to qualify
- Borrowers that receive alimony or child support
- Borrowers that have dividend income that they want to use for qualifying
What’s on the Tax Returns?
Your pay stubs and W-2s only show the income paid by your employer. If you have any ‘unique’ income, your tax returns show it. Tax returns are a complete picture of your income. They also show the expenses that you write off. This comes into play if you own your own business. The expenses come off your income, which can hurt you in the end.
It’s almost like a double-edged sword. You want to take the write-offs to lower your tax liability. It’s perfectly legal and recommended. But when a lender determines your gross monthly income, they will take into account the expenses you write off, which means they’ll use a lower income to qualify you for the loan.
What do Lenders Look At?
Lenders look at all of the aspects of your income. Where does it come from? How much is it? They will then determine if any or all of the income can be used to help you qualify for the loan. Keep in mind that any income that you don’t report on your tax returns definitely cannot be used for qualifying purposes.
Lenders pay close attention to your Schedule C and Schedule E. If you show a loss on either schedule, it could hurt your chances of loan approval. Again, it’s that double-edged sword. Lenders need to see that you make a financial gain and that it’s enough to support a loan. A loss certainly doesn’t support a loan.
The one exception to the rule is any depreciation expenses you claim on Schedule C. Lenders can add this back into your income. This isn’t a direct expense coming out of your pocket, so it doesn’t affect your bottom line.
Tax Returns Tell the Whole Story
In reality, tax returns tell lenders exactly what’s going on. You may omit the fact that you pay alimony or child support in your conversation, but your tax return will tell the truth. Lenders need to include this cost in your debt-to-income ratio. This compares your total income to your total debts. If your DTI is too high, you may not qualify for the loan.
Your tax returns also let lenders know if you have rental income, farm income, or unemployment income. All of these play a role in your loan approval. For example, if there’s unemployment income, the lender may need a Letter of Explanation detailing the gap in your employment and proof of how you’ve since recovered. The lender needs to know that this won’t be a recurring situation, such as happens with seasonal employment.
Lenders Request Transcripts From the IRS
Keep in mind, lenders will verify the legitimacy of your tax returns by requesting your tax transcripts from the IRS. The match the transcripts to the returns you provided to ensure that everything is as it seems. If there are any discrepancies, it could be a sign of fraud, which lenders take seriously.
Some borrowers won’t have to provide their tax returns, but it’s always a good idea to have yours ready. Lenders need the last two years of tax returns if they request them. This way they can take an average of your income, if there’s any income on the tax returns that isn’t reflected in a W-2. Lenders need to see your income patterns over the last two years to help them form an opinion of your ability to afford a loan moving forward.