Too often, Orange County real estate transactions fall out of escrow just when they are supposed to be closing. Why? While there are no specific statistics to back an answer to this question, 2106 expenses would seem to be good answer to that question. We know that appraisal issues have also been common in 2009, but too often tranactions fall apart because of the borrower qualification, even after they were supposedly "PreApproved." What are 2106 Expenses and why do they become an issue, at times, late into escrow?
What are 2106 Expenses?
2106 Expenses are also called Unreimbursed Employee Expenses. These are expenses some employed workers will writeoff on the Schedule A of their Federal Tax Returns. Typically, these expenses are associated with people who have a sales or commission based job. For example, if the borrower is not reimbursed for mileage, meals, hotel stays, license fees, or even basic business supplies, they are able to claim these expenses on their tax returns. This can result in a nice tax writeoff, but will also have an effect on the amount of home they will qualify for.
What Types of Jobs Will Typically Result 2106 Expenses?
Besides people in sales positions, just about anyone may have expenses they can write off. Of course, it may also depend on how aggressive the CPA is in advising their clients. It is not unusual for teachers to have unreimbursed expenses, as they quite often pay for supplies out of their own pocket. Some borrowers will get a little carried away and show some questionable expenses on their Schdule A. Its all fine and dandy until its time to qualify for a mortgage.
Why is This an Issue Now More Than Ever?
In the past, lenders did not request full tax returns from every borrower, even on a Full Income Documentation loan. 2 paystubs and 2 years W2's was enough. If there were expenses being written off, the lender never knew it because the additional information was never requested. Times have changed. Technically, lenders still don't require full tax returns in Prequalifying or even PreApproving a borrower for a mortgage. But lenders do require that Tax Transcripts be pulled from the IRS ON EVERY DEAL. This is what the Form 4506-T is all about. It used to be that the 4506-T form was only used after the close of escrow, if ever, as more of a Quality Control measure, making sure the borrowers had given the lender the tax returns which had actually been filed with the IRS. Rarely did this ever cause a problem, especially since most tranactions did not require tax returns anyway.
Now, lenders need to review a full set of 2 years Federal Tax Returns to make sure there are no surprises that come up late in a transaction. Some lenders will request the 4506-T form on the first day of the loan application, but some do not request Tax Transcripts until after the file has been underwritten, or worse, just prior to funding. This can easily create a situation where a deal is declined just a week before the moving vans are scheduled.
How Much Can this Effect a the Amount of Mortgage a Borrowers Qualifies For?
Lets say a school teacher has an annual salary of $75,000 a year, 800 FICO scores, one car payment of $300 per month, and 20 years on the job. She has $15,000 saved for the down payment. She is looking for an FHA approved condo in Irvine. Pushing the debt to income ratios, and making some basic assumptions for PITI plus HOA dues, this teacher would qualify for a purchase price of approximately $380,000. That would be pushing the debt to income ratios near the limit. But now lets assume that the teacher spends $10,000 a year in the classroom, keeping her class supplied with paper, pencils, and updated learning aides. Maybe she also has spent money on keeping herself educated on the latest teaching methods. The $10,000 in expenses needs to be deducted from her gross salary of $75,000. This is not much different than how a self employed borrower qualifies for a loan based on their income after expenses, not before. Based on $65,000 net income, this same teacher now qualifies for an approximate purchase price of $325,000. (this is still assuming an FHA purchase with 3.5% down payment.) That is a $55,000 drop in purchase power. That will kill a lot of deals if not caught during the PreQual and PreApproval stage of the process.
Mortgage PreApproval Needs to be Thorough
To make sure, or at least greatly decrease the chances of an ugly surprise at the end of escrow, the lender should request a full set of 2 years Federal Tax Returns on Day 1. And of course, the tax returns need to be reviewed carefully before issuing a Prequalifcation or PreApproval. There is too much time and money at stake in a real estate transaction to do it any other way.
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