Andrew asks:
We subtract federal taxes when calculating cashflow. Why aren’t the federal and state taxes reduced by the amount of the credits? For example on John Doe’s 1040, they had Total Tax of $4,349; tax credits of $2,152; so actual tax paid was $2,197.
We always take the figure from the “total tax” line and never even thought of earned credits. Should we take the amount owed instead?
Linda says:
This is a good question even if your financial institution does not subtract federal taxes and uses a pre-tax cashflow guideline like debt-to-income. Here is why…
Why care if you don’t subtract federal taxes
Many lenders do not subtract federal taxes at all. You may use a debt-to-income ratio based on pre-tax cashflow. That said, your guidelines are assuming a standard tax amount given the taxable income. If the borrower has significant tax credits that routinely reduce their federal tax, this could be a great compensating factor for a Debt Coverage Ratio that is a bit low or a Debt-to-Income Ration that is a bit high.
Why not count the credits?
You are correct that when we subtract federal tax and do not apply any credits, we are subtracting more than they actually paid. No one that I am aware of is routinely (or ever) reducing the tax figure by the credits. If they have thought about it (rather than just following formulas) I believe they are assuming those credits are not recurring.
Historical cashflow
If you are calculating historical cashflow, you could reduce the tax figure by the credits. They really did not spend the money. If the credits are significant and you do not, you’ll have a misleading picture.
Recurring cashflow
If you are calculating recurring cashflow and the borrower has similar amounts of credits year after year that are significant, I would offset the tax figure by them in that case. Since that is not routine, if your guidelines do not allow for it, use the information as a compensating factor.
