A lot has been written in how to calculate Debt Coverage Ratio’s on both investment and owner occupied transactions. One of the more complicated tasks of deriving the DCR is calculating all possible income out of the borrower’s tax returns.
Tax returns can become extremely complicated, very quickly. Take the typical owner occ deal. You have the business tax returns, the real estate entity returns and the borrower’s personal tax returns. All three are tied together yet have different tax shelter components within each.
In addition, there are areas where expenses are often reported twice. This of course can incorrectly reduce net income. Take, for example car expenses that are reported on both the business returns as well as on the borrower’s credit report. It is often the case that identifying little components of income like this, can separate a loan from floundering or closing.
Some of the major components of the tax returns to pay special attention to are: Depreciation, Interest Expense, Depletion, Business use of Home, Amortization, among others.
Depreciation is an accounting procedure to reflect the reduction in value of an asset over its useful life, used as a deduction for income for tax purposes. It is of course a non cash expense and can be added back to reflect the actual cash flow of the business/building.
Depletion is used most often in mining, timber, petroleum, or other similar industries. The depletion deduction allows an owner or operator to account for the reduction of a product's reserves. Depletion is similar to depreciation in that, it is a cost recovery system for accounting and tax reporting and is another non cash expense. It to, can be added back to reflect the actual net income of the business.
Interest Expense, on a refinance, is often referring to the interest paid on the loan being refinanced. Therefore this expense should be added back while you calculate the DCR. The new loan will replace this debt.
Business Use of Home is another one of those small details than can help a cash flow “tight” transactions. Business owners are allowed to report as much as 40% of their home expenses if they have a home office. This item will often be reported on their personal credit report as well, so look to account for that.
Amortization i.e. the principle pay down on an existing loan. It is often separated from the interest component for tax reasons as well. It can often be added back as income if it is referring to the amortization schedule of a loan that is being refinanced.
