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Sheilah asks:

Are capital gains ever considered a cash event and are they ever to be included in calculating cash flow available for debt service?

Linda says:

Yes and no. Love that answer, don’t you? Yes, they are often considered, depending on who you are lending to.

Consider using it:

  1. The borrower has recurring capital gains from sale of stock

    This can be true of they are retired and are supplementing their other retirement earnings with the sale of built up stock. To use this, you would need more than the 1040 Schedule D.

    Ask for the brokers statements for the years you are reviewing. Determine that they are withdrawing cash from the sale of the stock, rather than simply trading stock.

  2. The borrower has recurring capital gains from sale of real estate

    Real estate investors often have a signficant amount of their cash flow coming from sale of real estate. So if you routinely disregarded capital gains from real estate, you might be way off.

    First look at their application and find the Real Estate Owned schedule. Does it show purchases during the period? If so, they may be selling some and buying other real estate. You would need the Real Estate Closing Statements to establish the cash to seller for the properties they sold and the cash from buyer for the properties they purchased to determine net impact on cash flow.

  3. The borrower has a significant portfolio

    I work with several national banks that focus on lending to the wealthy. Some of them will take the stock portfolio and ‘annuitize’ it over 30 years or so to determine the cash flow the borrower could safely pull by selling off stocks. Some will reduce that to 20 years if the borrower is retired. And some will give the portfolio a ‘haircut’, reduce it to 80%, before making this calculation to be more conservative.

    Caution: You cannot use the portfolio as an income source and also use it as part of their liquidity.

Don’t use it:

  1. Follow your guidelines

    Perhaps your financial institution rarely works with borrowers in the above circumstances and you have a hard and fast guideline directing you not to use it.

  2. It is not recurring.

    Although, if cash flow was derived from the sale of a capital asset, consider what they did with it. Perhaps that is where they got the funds to invest in their business. Or maybe it is why, that year, they were able to take less in compensation from their business to weather a storm.

Judgement and Guidelines

Much of tax return analysis for any type of lending comes down to judgement and guidelines.

More on Capital Gains and the Schedule D

1040 D Module Image 2015 10

The module on Schedule D Capital Gains, available at LendersOnlineTraining.com, answers the questions:

  1. Which numbers are cash flow and which are not?
  2. What is the one number that can throw you way off
  3. When might you need more than just the D or 4797?
  4. Where do you get the missing information?

See the preview at LendersOnlineTraining.com/modules/.

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Linda Keith, CPA

Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis.
She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans.
Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.