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will require a complete set of income tax returns for at least the three
most recent years of operations. Gross income from self-employ-
ment usually includes ordinary income or profit from the borrower’s
primary business and investment income generated from rental
properties. In some cases, a borrower’s self-employment business
may consist solely of the ownership and management of commercial
real estate. In this type of sole proprietorship, the borrower’s person-
al or gross income is derived from the net cash flow from the own-
ership of real estate. In either situation, a lender will need to compare
the borrower’s business income statement with the income tax
returns for that same calendar year. The borrower’s business income
statement will have to be reconciled with the income tax returns. If
the business income statements differ significantly from the tax
returns, the tax returns will always supersede. Occasionally, lenders
will order transcripts from the IRS and discover that income tax
returns given to the lender do not match the returns actually filed
with the IRS. A transcript is a computerized version of the signed tax
return filed with the IRS with all its schedules, referred to as IRS
Form 4506-T. If the transcript is different from the returns that the
borrower claims to have sent to the IRS, the lender may suspect
fraud and decline the loan immediately.
Net Cash Flow and Taxable Net Cash Flow from Rental
Income
Net cash flow specifically refers to income derived from real estate
investments such as single-family and commercial properties. Net
cash flow can be the borrower’s sole income, or it can be additional
income that is added to a borrower’s primary income such as a salary.
Anytime a significant portion of gross income is coming from aggre-
gate net cash flow (refer to Figure 3-2), it’s usually a pretty good indi-
cation the borrowers are professional real estate investors engaged
full time in the real estate business. Net cash flow is not to be con-
fused with net operating income (NOI). As discussed in Chapter 2, net
operating income is cash flow available before debt service and is not
passed through to the owner, at least not yet. Net cash flow, on the
other hand, is cash flow available after debt service. Net cash flow,
assuming it represents a profit, is the income from a rental property
that is finally passed through to the owner. As illustrated in Figure 3-
3a, net cash flow is simply calculated by subtracting nonoperating
expenses from the property’s NOI, such as mortgage interest, legal
and professional fees, and administrative and management fees
associated with the partnership. Nonoperating expenses are actual
costs that are not integral to the operation of the property, also
referred to as below-the-line expenses. Operating expenses and nonoper-
ating expenses alike are cash expenses. Cash expense are those expenses
or costs that require an actual outlay of cash. A noncash expense, such
as depreciation and amortization, is a cost that does not involve an
actual outlay of cash and is only an accounting adjustment used in
preparing financial statements and tax returns. Subtracting noncash
expenses from net cash flow, such as depreciation and amortization,
results in a taxable net cash flow. Net cash flow can also be used to cal-
culate a borrower’s return on equity, also referred to as cash-on-cash
return.
Taxable net cash flow is calculated strictly for the purpose of reduc-
ing a borrower’s tax liability. As illustrated in Figure 3-3a, deprecia-
tion and amortization, for example, are noncash expenses that
reduce a borrower’s net cash flow from $15,000 to $5,000. In this
example the borrower actually earns $15,000, but only pays taxes on
$5,000. Lenders are fully aware of these noncash expenses and take
them into account when calculating the borrower’s actual net cash
flow. Figure 3-3a illustrates the calculation of and the difference
between net cash flow and taxable net cash flow.
Financial Strength and Creditworthiness
121
Aggregate net cash flow from real estate income, as shown in Figure 3-
2, is a sum of the net cash flow from each and every real estate invest-
ment or income-producing property within a borrower’s portfolio.
However, it is important to note that the total income or loss shown
on the borrower’s tax return (Form 1040, Schedule E) is actually the
aggregate taxable net cash flow, which is most often a negative num-
ber or in other words shown as a loss instead of positive income.
Lenders are fully aware of this issue and often just add back depreci-
ation and amortization to the aggregate taxable net cash flow in order
to calculate or re-establish a borrower’s true aggregate net cash flow.
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Commercial Mortgages 101
Figure 3-3a. Net Cash Flow vs. Taxable Net Cash Flow.

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