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Why Gross-up Tax Exempt Interest?

Elvin asks:

In your manual (Tax Return Analysis: Fundamentals and 1040 Review), you recommend multiplying tax-exempt interest, listed on 1040 page one (Line 8b), by a factor of 1.2 to 1.25. I don’t understand why you would multiply tax-exempt interest by 1.2 – 1.25 in cash flow calculations. If, for example, an individual shows $5K in tax-exempt interest, does that mean they are actually receiving $6,250 ($5K * 1.25)? Why?

Linda says:

Multiplying tax-exempt interest income shown on the front page of the 1040, Line 8b is only done by lenders who do not subtract federal taxes, and not by all of them.

What is ‘grossing up’ and why do we do it?

‘Grossing up’ refers to converting non-taxed income, like tax-exempt interest, into it’s taxable equivalent. This is done by lenders who use a guideline, like debt-to-income, that assumes all income is taxable income. That is just not the case.

As long as the non-taxed income is not significant, it does not make a large difference. If it is, though, the lender considering a borrower’s cashflow available to pay debt is not counting the true impact of the nontaxed income.

As an example, if I have non-taxed social security of $8,000, I get to spend the entire $8,000. If I have taxed income of $10,000, at a 20% tax bracket, I have to pay $2,000 in taxes and get to spend $8,000. So $8,000 non-taxed is equivalent to $10,000 taxed.

$8,000 * 1.25 = $10,000. By multiplying the non-taxed income by 1.25, we give them credit for the taxable equivalent of $10,000. When we apply the debt-to-income ratio to that number, it takes into account that some of the taxable income is unavailable due to federal taxes.

Does this only impact tax-exempt interest?

If you are allowed to make this adjustment, your guidelines will tell you what types of income you can apply it to. Common non-taxed items that some lenders gross up include:

  • Tax-exempt interest
  • Child support received
  • Untaxed portion of social security, pension or IRA income

For a longer list of possible non-taxed income to include and to gross-up, check out this post on Nontaxed income to add back…a sad tale!!!

EXCEPTION: Do you subtract federal taxes?

If you subtract federal taxes, do not multiply non-taxed income by the factor mentioned. You are likely using a guideline related to after-tax income. For example, farm lenders and others who do a global analysis including both the business and one or more guarantors often use a guideline, debt coverage ratio, that is calculated after federal tax is subtracted.

To answer your last question…

In your example, the borrower received $5,000. But it had the impact of $6,250 before taxes. Check your guidelines as to whether you are allowed to ‘gross up’ any non-taxed income and, if so, what is on your list.

More to the story…

Finding and including non-taxed income in cash flow, whether you gross it up or not, is one of my ‘Six Ns to Cashflow Analysis’. Here is more on this first of six steps.

Non-taxed income covered in one of our free modules

Free modules at Lenders Online Training
The module on Green Legos, Six Ns and a Map to Tax Return Analysis covers non-taxed income plus the other five types of income you must find, and adjust, to determine cashflow available to pay debt and to pay the owners of a business. Click here to access these free modules.