Personal Income and Cash Flow

Personal Income and Cash Flow

In addition to net worth, liquidity, and good credit, borrowers must
have adequate cash flow. There are many terms used to describe personal cash flow, such as disposable income, net income, gross
income, net cash flow, and free cash flow. Disposable income and net
income both refer to the amount of income or earnings remaining
after payment of federal, state, and local taxes, also referred to as
“take-home pay” or “after-tax income.” Gross income refers to the
amount of total income or earnings before payment of taxes. Net cash
flow refers to cash flow or income remaining after payment of mortgage interest and other non-operating expenses associated with real
estate investments. Free cash flow refers to the amount of gross
income remaining after paying living expenses, including payments
on home, auto, student, and consumer loans. Financial terms, such as
gross income, net income, and the like, can be confusing and may
have similar or even double meanings. In fact, the term “free cash
flow” may even be new to you or even new to most lenders. But
despite its unusual name free cash flow is nothing more than surplus
cash that could be used in the event of financial hardship.
Our discussion of free cash flow refers only to a borrower’s gross
income before income taxes. As illustrated in Figure 3-2, income
taxes are not included in the calculation of free cash flow. In our society, when we speak of someone’s annual income or salary, we usually mean total earnings before income taxes. The lenders realize that,
so, in speaking of personal income and free cash flow, it is not necessary to deduct income taxes. It’s important to note that free cash
flow should not be confused with disposable income. Disposable
income simply refers to after tax income.

Gross income i

Gross income is the sum of all earnings or income from wages,
salaries, self-employment, interest, dividends, and net cash flow
from rental properties before the payment of federal, state, and local
income taxes. A borrower’s primary source of income is usually from
a salary (for a W-2 employee) or earnings from self-employment. A
borrower may also be both a W-2 employee and self-employed
through a side business. If a borrower has multiple sources of
income, it’s important to explain in detail the frequency with which
these additional sources of income occur. For example, if a borrower
sold an asset such as a fourplex and had a capital gain of $100,000,
this income is considered a one-time event. One-time events, such as
capital gains, are not considered reliable sources of income and must
be excluded in calculating gross income. Often borrowers buy and
sell properties for a living and live primarily on the capital gains. In
this situation, the capital gains are recurring and relatively reliable.
Nevertheless, borrowers must disclose whether or not these sources
of income are recurring. If a borrower is a W-2 employee, it is fairly

safe to assume that his salary is fixed and therefore a reliable source
of income. All other sources of income must be verified by pay stubs
and tax returns. Large sums of income should be described as either
stable, recurring, or one-time events.
In general, borrowers should report only income that is consistent and reliable year after year. As a side note, it is extremely difficult to calculate actual gross income using tax returns because of the
inordinate number of deductions, write-offs, and exemptions
allowed by the IRS. The process of reconstructing a borrower’s true
gross income using tax returns is daunting and very time consuming. Often lenders employ or hire a third party to do this analysis for
them. Examples of different sources of income include the following:
Wages and salaries (W-2 )
Bonuses and commissions
Interest and dividends
Business income (self-employment)
Capital gains
Rental income
Partnerships and joint ventures
Trusts
Oil and gas royalties
Alimony and child support
Annuities and retirement distributions
Social Security
Self-Employment Incom

Self-Employment Income

Borrowers who are self-employed are scrutinized more carefully than
borrowers who have stable salaried jobs. A lender will need a brief
description of the type of business the borrower owns and its history
of revenue. In addition to business financial statements, the lender
will require a complete set of income tax returns for at least the three
most recent years of operations. Gross income from self-employment usually includes ordinary income or profit from the borrower’s
primary business and investment income generated from rental
properties. In some cases, a borrower’s self-employment business
may consist solely of the ownership and management of commercial
real estate. In this type of sole proprietorship, the borrower’s personal or gross income is derived from the net cash flow from the ownership of real estate. In either situation, a lender will need to compare
the borrower’s business income statement with the income tax
returns for that same calendar year. The borrower’s business income
statement will have to be reconciled with the income tax returns. If
the business income statements differ significantly from the tax
returns, the tax returns will always supersede. Occasionally, lenders
will order transcripts from the IRS and discover that income tax
returns given to the lender do not match the returns actually filed
with the IRS. A transcript is a computerized version of the signed tax
return filed with the IRS with all its schedules, referred to as IRS
Form 4506-T. If the transcript is different from the returns that the
borrower claims to have sent to the IRS, the lender may suspect
fraud and decline the loan immediately.


Net Cash Flow and Taxable Net Cash Flow from Rental
Income

Net cash flow specifically refers to income derived from real estate
investments such as single-family and commercial properties. Net
cash flow can be the borrower’s sole income, or it can be additional
income that is added to a borrower’s primary income such as a salary.
Anytime a significant portion of gross income is coming from aggregate net cash flow (refer to Figure 3-2), it’s usually a pretty good indication the borrowers are professional real estate investors engaged
full time in the real estate business. Net cash flow is not to be confused with net operating income (NOI). As discussed in Chapter 2, net
operating income is cash flow available before debt service and is not
passed through to the owner, at least not yet. Net cash flow, on the
other hand, is cash flow available after debt service. Net cash flow,
assuming it represents a profit, is the income from a rental property
that is finally passed through to the owner. As illustrated in Figure 3-
3a, net cash flow is simply calculated by subtracting nonoperating
expenses from the property’s NOI, such as mortgage interest, legal
and professional fees, and administrative and management fees
associated with the partnership. Nonoperating expenses are actual
costs that are not integral to the operation of the property, also
referred to as below-the-line expenses. Operating expenses and nonoperating expenses alike are cash expenses. Cash expense are those expenses
or costs that require an actual outlay of cash. A noncash expense, such
as depreciation and amortization, is a cost that does not involve an
actual outlay of cash and is only an accounting adjustment used in
preparing financial statements and tax returns. Subtracting noncash
expenses from net cash flow, such as depreciation and amortization,
results in a taxable net cash flow. Net cash flow can also be used to calculate a borrower’s return on equity, also referred to as cash-on-cash
return.
Taxable net cash flow is calculated strictly for the purpose of reducing a borrower’s tax liability. As illustrated in Figure 3-3a, depreciation and amortization, for example, are noncash expenses that
reduce a borrower’s net cash flow from $15,000 to $5,000. In this
example the borrower actually earns $15,000, but only pays taxes on
$5,000. Lenders are fully aware of these noncash expenses and take
them into account when calculating the borrower’s actual net cash
flow. Figure 3-3a illustrates the calculation of and the difference
between net cash flow and taxable net cash flow.
Financial Strength and Creditworthiness 121
Aggregate net cash flow from real estate income, as shown in Figure 3-
2, is a sum of the net cash flow from each and every real estate investment or income-producing property within a borrower’s portfolio.
However, it is important to note that the total income or loss shown
on the borrower’s tax return (Form 1040, Schedule E) is actually the
aggregate taxable net cash flow, which is most often a negative number or in other words shown as a loss instead of positive income.
Lenders are fully aware of this issue and often just add back depreciation and amortization to the aggregate taxable net cash flow in order
to calculate or re-establish a borrower’s true aggregate net cash flow.
122 Commercial M

Aggregate net cash flow from real estate income, as shown in Figure 3-
2, is a sum of the net cash flow from each and every real estate investment or income-producing property within a borrower’s portfolio.
However, it is important to note that the total income or loss shown
on the borrower’s tax return (Form 1040, Schedule E) is actually the
aggregate taxable net cash flow, which is most often a negative number or in other words shown as a loss instead of positive income.
Lenders are fully aware of this issue and often just add back depreciation and amortization to the aggregate taxable net cash flow in order
to calculate or re-establish a borrower’s true aggregate net cash flow.
122 Commercial Mortgages 101
Figure 3-3a. Net Cash Flow vs. Taxable Net Cash Flow.
For example, if taxable net cash flow (same as “inco

For example, if taxable net cash flow (same as “income” or “loss” on
page 1 of Schedule E) for a single investment property is $5,000, and
depreciation and amortization expenses are $8,000 and $2,000,
respectively, net cash flow can be simply calculated by adding $8,000
and $2,000 back to taxable net cash flow. Figure 3-3b illustrates how
taxable net cash flow is converted back to net cash flow.
But more often than not, a borrower will own a dozen or more
properties vested in a dozen or more partnerships, which in turn creates a convoluted web of tax returns too complicated to comprehend.
Despite this reality, some lenders will forge ahead anyway, no matter
how complicated tax returns may be. However, many lenders prefer
to use a much faster, if not easier, method in calculating aggregate
net cash flow. Instead of using tax returns or financial statements
(which are really one and the same, since accountants use the financial statements to prepare the tax returns), a lender will use an Excel
spreadsheet, referred to as a Real Estate Owned Schedule (REO
Schedule). This method is discussed in greater depth in Chapter 5

Cash Flow Statement

As mentioned earlier, free cash flow is the monthly or annual amount
of gross income remaining after paying living expenses, including
payments on home, auto, student, and other types of installment
loans. Free cash flow is usually calculated using a cash flow statement,
such as the one illustrated in Figure 3-4. The cash flow statement
looks very similar to a business income and expense statement
except that the income section is referred to as “sources of cash” and
the expense section is referred to as “uses of cash.” A cash flow statement pertains to personal cash inflows and cash outflows only,
unlike a typical business or property income and expense statement,
which uses an accrual accounting method that includes both cash
and noncash income and expenses. There are business cash flow
statements prepared by CPAs, and there are personal cash flow statements prepared by individuals. Lenders prefer personal cash flow
statements, similar to the one illustrated in Figure 3-4. Preparing an
accurate and truthful cash flow statement can take hours or even
days, and the statements are often inaccurate and incomplete. The
integrity of a personal cash flow statement is dependent on the honesty of the borrower. In order to pinpoint any discrepancies, lenders
often compare the total amount of personal debts listed on the borrower’s cash flow statement to the total amount of debts reported on
the credit report. If a discrepancy is found, borrowers must either
correct the mistake or provide an explanation. Lenders can often verify income reported on a cash flow statement using tax returns but
the same does not hold true for expenses. With the exception of
mortgages, auto loans, and credit cards, which can be verified using
a credit report, household and living expenses are merely estimates.
A cash flow statement should always be signed, dated, and certified
by the borrower. A cash flow statement that is certified is one that has
been authenticated and represents a true, complete, and correct
statement of financial condition.

Thank you.

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