Eryl’s question:
We use Capital Gains from 1040 Schedule D and actual cash flow from Schedule K-1 when our borrower is an owner of a paas-thu entity. Are we double-counting if we use both schedules in our income qualification?
Linda says:
The short answer is ‘probably’. It depends on what line the gain/loss is reported on Schedule D. And it depends on whether your focus is the owner or if you are lending to the entity and doing a global analysis.
Focus on the Owner:
Non-cash Entries on Schedule D
The first thing I do with a Schedule D if I am interested in recurring cashflow available to pay debt is decide if the listed gains or losses are non-cash. These come in two categories.
- Carryovers are reported on Line 6 if short-term and Line 14 if long-term. In either spot, this is another chance to write off a prior year loss that was limited by the $3,000 maximum net loss allowed for capital losses in a prior year.
- K-1 pass-thru gains or losses are also non-cash. They are reported on Lines 5 or 12. While your underwriting guidelines may allow you to use these figures instead of obtaining the K-1s, most lenders in my experience do not use pass-thru as cash flow.
What to use instead…
For K-1 pass-thru gains and losses most lenders will either use actual cashflow as evidenced by the K-1 or they will use cashflow available as evidenced by the full return of the pass-thru entity.
Use actual K-1 cashflow if you are not going to use the borrower’s share of available cashflow based on a review of the full return. This is often determined by % ownership.
Your guidelines might use K-1 cashflow if the ownership is less than 20%, or perhaps 25%. I cannot tell you which because guidelines vary from one financial institution to the next.
Some financial institutions use a guideline based on % of income instead. So I might be a 15% owner but my income is substantial and primarily from this pass-thru entity.
And some will always get the full return if the owner is a general partner on a partnership since by definition, that borrower has liability for all debts regardless of % ownership.
This is one area where I will not hazard a guess as to your guidelines and instead tell you to check.
Use available cashflow from the full 1120S or 1065 when your guidelines say to do so. If the entity had capital gains it will show up on Schedule K and come from the entity’s Schedule D. If you think it is recurring, give the entity credit for it.
Then when you calculate your borrower’s share you will be giving them credit for the recurring cash flow from entity capital gains.
Focus on the Entity: What about global cashflow?
This changes things. When you are lending to the pass-thru entity you might do a global cashflow combining the cashflow of the entity with the cashflow of the owner/guarantors.
Do not use 1040 Schedule D Lines 5 or 12 in the guarantor analysis if you are considering the Capital Gains as continuing cashflow at the entity level or you will double-count.
Need more help?
This is a challenging question for which to provide a brief answer so here are some options of that just flew right over your head.
- Read the section in our 1040 manual on Schedule D and the sections in our business returns manual on pass-thru entities. Don’t have the manuals? comprehensive self-study manuals .
- Take the online self-study modules on Capital Gains here and/or the six modules on the Pass-Thru Entities here. Each is 30-minutes-or-less and includes handouts.
- Join our next virtual class on Tax Return Analysis here. The class includes both manuals, 21 online modules, live webinars, instructor-reviewed case studies and an online discussion group.
