Why is AGI Not a Good Indicator of Cash Flow to a Borrower?
We have heard this question and/or argument since we started teaching Taxanalysis almost 40 years ago. Some people want to keep their tax return analysis “simple” because it makes them more “efficient,” even though AGI and AGI-based approaches lead to amazingly wrong cash flows. That has never been more true than in today’s tax environment.
The worst thing about AGI-based approaches to personal cash flow is it leads to overstated cash flows. In other words, the borrower appears to have more cash flow than is really true. The loan officer lends against this incorrect overstated cash flow, the loan defaults and the loan officer asks, “What happened?” In a nutshell, the lender assumes that AGI and Taxable Income reported on page 1 of Form 1040 are actual cash flow. They are not. Taxable income and actual cash flow are two entirely different things.
Here are just a few scenarios to think about:
- Salary can be overstated in the hundreds of thousands by the exercise of stock options. The “paper” gain upon exercise of the options gets added to salary and suddenly we have cash salary of $60,000 go to $360,000 and $300,000 of it is “paper.”
- Take a developer or high-income individual with large interest and dividend income passing through to Schedule B from a K-1. Suddenly interest income zooms from $6,000 cash interest and dividends to $42,000 and $36,000 is “paper.”
- Schedule D has a $525,000 gain pass through from a K-1 on a partnership real estate sale where the actual cash distributions related to it were only $125,000. In this case, almost all the sales proceeds of the property were used to pay off debt encumbering the asset at time of sale so there was very little available to distribute from the partnership.
- Partnership income passed through and reported on the Schedule E totaled $325,000 when distributions were only $165,000. Or S corp income…ditto.
It just goes on and on. To properly “correct” AGI back to real cash flow, we find there are no less than 87 adjustments that need to be made. Without every one of those adjustments, you are left with overstated cash flows. If you’re using an AGI-based system you have this problem and may not realize it. The Federal and State regulators are acutely aware of this issue. Accurate cash flow analysis requires careful thought and attention to detail. There are no shortcut “exceptions.” Don’t be caught by this!
Our Bukers Online Academy teaches the theory laid out above, and so much more. If you’re a lender or analyst who wants to take your analysis to the next level, enroll in Bukers Online Academy today. We break down all these topics into interactive learning modules to teach the advanced concepts necessary to analyze the most complex tax returns.