This is a somewhat tricky question. You should declare all income or risk the IRS coming after you.
The bigger question is not so much declaring all income (the top line) but clients seem to have questions on whether over deducting on expenses could hurt them.
You have legitimate expenses and the legal ability to take full advantage of expensing these on your tax returns but the draw back is that then you may have created a negative cash flow situation on paper that then gets deducted from your other income stream in qualifying for future loans.
So for example: Let’s say you earn $5000 in your job or business and have very few consumer debts. You then buy a duplex and have $18,000 in gross income the first year but you deduct all kinds of expenses including going to the property which is another state gas to get around while there, part of your cell phone bill, you deduct the classes you go to as an investor to educate yourself, etc. You end up with a negative $5000 (which is $416 per month), we as mortgage lenders have to count that negative $416 per month as if it were a car loan in your debt to income ratio. So, one of these paper negative properties is ok but imagine if you do this with 2 or 3 properties making that $1300 per month, you may hurt your chances to qualify for another loan or have to take a higher interest loan to do future deals.
Conventional qualifying differs greatly from commercial/residential qualifying.
You can have as many negative cash flow properties with conventional financing as you can afford on paper. Fannie Mae and Freddie Mac guidelines do not require properties to have positive cash flow, they look at the borrower’s personal ability to carry the debt.
If you don’t plan to ever borrow again then go ahead and be heavy handed with the tax deductions/expenses but I bet like most of us, you are still building your portfolio and therefore borrowing.
Multi family is different!
If you are borrowing for a 5+ unit building, the building has to cash flow to get a certain loan amount, they call this the DSCR (debt service coverage ratio) kind of like you personal DTI (debt to income ration). If that number is low cause you took lots of deductions (or the seller did in a purchase) lenders will lower the amount you can borrow til they get that magic number.
For example, if you are borrowing against your apartment complex (5+ units) and it makes a gross of $2000 but you wrote off lots of expenses down to $800 per month net, then the lender will let you borrow only $667 per month (loan amount of about $115,000). They do this to maintain their DSCR of 1.2:1 – in other words they want a 20% profit margin or cushion above the mortgage payment. If you write off down to $1200 you can have a mortgage payment $1000 (loan amount of about $175,000) – huge $60,000 difference in borrowing power!
That’s the cost of over deducting. And in commercial lending/qualifying, by over expensing you are also making the property worth less since it makes less, a big problem if you want to resell the property sooner than later. As a mortgage consultant, I have a whole hour-long class on this topic so this is definitely the short version, but I hope it helps give you perspective.
About Athena Paquette