By the time homebuyers arrive at the settlement table, they may feel as though they’ve handed over enough paperwork to sink a ship. When you’re working with a lender on a mortgage application, tax returns are one of the many documents you may need to provide for review.
Before you start the process of applying for a mortgage, it helps to gather your personal documents, like pay stubs, bank statements, and retirement plan balances. Lenders will want detailed information to substantiate the income and expense amounts you report on your application. If your lender requests tax information, don’t balk. Tax returns provide important insight into your finances and help determine if you qualify for a loan.
Why do mortgage lenders need tax returns?
Lenders must evaluate your ability to make a monthly mortgage payment. This means that the borrower should earn enough income to cover the scheduled repayment of the loan over time after backing out household expenses and amounts owed for other obligations, such as credit card debt or student loans. Your loan application provides some of the information needed, but lenders will typically pull your credit report and also request additional paperwork, including recent tax filings.
The information received from all sources filters into a calculation of your current debt-to-income ratio. The amount of your proposed mortgage payment will also be factored into the calculation. This final ratio of debt to income generally needs to meet the lender’s benchmark to move forward with the mortgage process.
Tax returns also provide another source of identification and validation. During the mortgage application and approval process, you may also sign a 4506-T form. This form gives the lender permission to request an official transcript of the tax return you filed. The tax transcripts delivered from the IRS serve as an independent verification of information provided on your loan application. They also provide proof that homebuyers filed their tax returns.
When do mortgage lenders request tax returns?
The mortgage lending process often starts with a prequalification or a preapproval. A prequalification gives borrowers an estimate of how much they may be qualified for. This amount can help a house hunter set a price range when buying.
Alternatively, preapproval is a much more involved process. The lender will request information about your income, and they may also check your credit report. You may need to provide tax returns, along with other financial documentation, as part of the preapproval process.
The extra time required to obtain preapproval can help when you place an offer on a home. Sellers may prefer to work with preapproved buyers who understand the homebuying process and have already taken steps to secure a mortgage loan. When a seller accepts your offer to buy a home, the mortgage process continues, and buyers complete the loan application.
After the lender reviews your loan application, they will request additional information. The lender requests any remaining support needed to complete your application. A home appraisal will also be completed and added to the file during this stage of the process. Then, everything is forwarded to the underwriting department to determine if a borrower meets the lender’s standards to qualify for a loan.
What pages of tax returns are needed for a mortgage?
When a lender requests copies of your tax returns, they typically want to see everything filed. Although the first two pages of Form 1040 provide a summary of your taxable income for the year, lenders may want to dig deeper. If you own a business or part of a business, they may request copies of company tax returns as well.
What do mortgage lenders look for on tax returns?
Lenders closely review specific line items to determine the amount of income they can factor into their loan qualification decision. Basically, they’re looking to substantiate the amount of income you plan to use to buy and pay for your home. Tax returns may also serve as verification of demographic information stated on your application form.
Don’t be surprised if your lender requests two years’ worth of tax returns, as income varies from year-to-year. The multi-year look helps to identify one-time events such as a large investment sale or one-time payment you received. Larger one-time items reported on your tax return that will not affect future earnings may be backed out of your income calculator for mortgage approval purposes.
The total amount of personal income reported on your tax return should match your W-2s and what was reported on your application. Because your various sources of income could change, don’t hesitate to ask your lender if you can provide additional information that would help you qualify. For example, a recent pay raise or a new source of earnings not reflected on your last return may help lenders make a decision.
Business income and expenses
If you own a business or part of a business, mortgage lenders will look not only at the gross income reported on your business return but also at your expense deductions. They want to understand your bottom line or the net profit from your business. This determines the available income you generate to pay non-business expenses, such as a mortgage.
Take note that your business income may be adjusted by lenders when considering your mortgage application. For example, depreciation expense can sometimes be removed from lenders’ calculations as the amounts reported on your tax return do not affect your current cash flow.
Schedule E income
Schedule E of Form 1040 reports supplemental income and losses from activities such as investments in real estate, trusts and estates, partnerships, or S-Corporations. Income from these ventures also factors into your mortgage approval. If you own rental properties and report the profit or loss on Schedule E, the lender may request an additional document known as a rent roll—basically an overview of your investment properties—to help them determine the amount of money you’re spending to maintain your rentals compared to the amount of income you collect. Leases and other documents may also be requested to substantiate rental income.
As you work through the mortgage approval process, don’t hesitate to ask questions or offer additional information to support your application. Mortgage loans can make a significant impact on your monthly expenses and lenders want to see proof of your ability to keep up with the payments. Before lenders approve a new loan, they often need to perform an in-depth evaluation of your finances, including a review of your tax returns.
Mortgage lenders ask potential homebuyers for their tax returns to verify their financial background, ultimately helping them decide how much to provide on a mortgage loan. Lenders go through all portions of the most recent two years of tax returns to look through income and expenses, the story behind one-time payments, and finances related to business activities. Homebuyers can ask their mortgage lenders to provide extra information about
Jennifer DiGiovanni is a freelance writer, an author, and a small business owner. She previously worked in the financial services industry and received an MBA from Villanova University. Jennifer enjoys writing about real estate, small business, personal finance, and home improvement.