As reporters and politicos have discovered a newfound interest in net operating losses, many mortgage industry veterans are still hard-pressed to explain a net operating loss and the impact on qualifying. What is a Net Operating Loss and how does it impact mortgage qualification for income purposes?
A Net Operating Loss, more commonly shown as NOL, occurs when a business has a greater amount of allowable tax deductions than its taxable income. This results in a negative taxable income. While this generally occurs when a company’s expenses have exceeded their revenues for the defined time period, it can also occur as a result of allowable tax deductions that may be “paper” in nature only, such as depreciation.
A person or company may be able to carry the non-deductible portion of the loss forward to be applicable against future years. This is a Net Operating Loss carryforward and can be used to offset taxable income in another reporting period. A single year showing a NOL can result in a NOL carryforward showing on multiple tax years.
A NOL does not result in an actual cash expenditure for the business and is not generally considered to be a recurring expense. As a result, agency guidelines permit a net operating loss to be added back for qualifying income purposes for a residential mortgage. Net Operating Loss is a scenario commonly faced for self-employed borrowers and an understanding of their impact is critical for both originators and underwriters.
The differing nature of mortgage guidelines, vs IRS requirements, can be very confusing to industry newcomers and borrowers alike. Other non-cash expenditures, much like net operating loss, can be handled in very different fashion for tax and qualifying purposes. Additional examples of these expenditures will be explored in coming weeks.