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Construction lending

Ben asks:

I have a borrower who owns 100% of an S-Corp. The S-Corp is a construction company and it also has a large rental portfolio. Its ordinary income has declined from 2011-2012, but its rental income was a positive $250k in the most recent year up from $190k the prior year, thus increasing. The underwriter is stating since the ordinary income went down I cannot use the rental income or add back the depreciation from the 8825. What are your thoughts?

Linda Says:

This is a tough one if you are working on a mortgage loan, perhaps less tough if you are working on any other kind of loan. In my view, the fact that the ordinary income declined is not relevant. If it were relevant, we would never spend the kind of time we spend converting taxable income (which is what ordinary income is) into cash flow.

Convert to Cash Flow

Since you say your borrower is the owner, not the S Corp, I would look at two things:

  1. Take a look at the K-1s for the two years. What are they taking out of the S Corporation? Line 16 with a code of D is distributions, and is one of two numbers on the S Corporation K-1 that represents cash flow to the owner. (The other is Line 16 with a code of E representing repayment to the shareholder of loans made to the company).

    Is the actual cash flow to the owner stable? Consider the wages from the S Corporation as well. Since your borrower is a 100% owner, I would not use the K-1 cash flow, but I’d be curious.

  2. Calculate cash flow for the S Corporation for all activity including the rental cash flow. Note I said cash flow, not income. Truly, I just do not care about rental taxable income and it is dangerous to draw conclusions from it. (I’ll explain why, next.)

    If the overall cash flow for the corporation is negative, now the underwriter has a point. But not because of a change in taxable (ordinary) income.

Construction Companies and Farmers

Lending to and tax return analysis of construction companies is a bit different. The same is true for farm lending. These types of companies often have a multi-year operating cycle. If your borrower has a long (and successful) history in construction, consider what part of the cycle the projects were in during the time-frame under consideration.

But also consider what was happening to real estate and construction in that geographic area during that time-frame. Those are considerations that might be a compensating factor, or an explanation for the underwriter, as to why you want to use the S Corporation cash flow.

This might work against you

Consider, also, that if the S Corporation really is in trouble, and the S Corporation shareholder was paid wages from the company, an underwriter might actually want to discount the wages, or pull the borrowers 100% share of the S Corporation cash flow deficit against the borrower. You actually might be in worse shape by convincing an underwriter to consider an S Corporation cash deficit in a loan to the owner.

Performing vs. Qualifying

Another variation in mortgage lending is the difference between making a performing loan and making a qualifying loan. If your company were planning to keep the loan in your portfolio, you might have more flexibility to consider some of the factors I mentioned above. When you are selling the loan, you must meet the guidelines of the lender buying the loan. In that case, if this underwriter is clear on their guidelines, you may be stuck. But if the underwriter has more judgement than it appears, some of the suggestions I made above may be compelling to the underwriter.

Danger of Premature Conclusions

There is scientific evidence that once you draw a conclusion, your brain actively searches for evidence to back it up and might disregard evidence to the contrary. In auditing and in lending, we often call this ‘confirmation bias’. In psychology, this is called Heuristic Decision Making. (I love science!) Here is what it means, direct from Wikipedia:

“A heuristic technique (/hjᵿˈrɪstᵻk/; Ancient Greek: εὑρίσκω, “find” or “discover”), often called simply a heuristic, is any approach to problem solving, learning, or discovery that employs a practical method not guaranteed to be optimal or perfect, but sufficient for the immediate goals. Where finding an optimal solution is impossible or impractical, heuristic methods can be used to speed up the process of finding a satisfactory solution. Heuristics can be mental shortcuts that ease the cognitive load of making a decision. Examples of this method include using a rule of thumb, an educated guess, an intuitive judgment, stereotyping, profiling, or common sense.” (Emphasis mine)

Premature judgement or following guidelines

Our problem in lending is that phrase ‘not guaranteed to be optimal or perfect’. While no lending professionals believe our decision-making is optimal and/or perfect, we definitely need to avoid making judgements too early. The underwriter saw a dropping taxable (ordinary) income and applied a ‘rule of thumb’ that I do not believe was justified. Was s/he coming to a premature judgement or was s/he following guidelines. I cannot tell.

More on S Corporations and K-1s

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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.