So, you are ready to buy or refinance. For homebuyers, there is one central question in the new climate of regulation: Is your lender an arm of the IRS (Internal Revenue Service)?

Since the “mortgage meltdown,” numerous consumer protection laws have been implemented by both federal and state legislatures. Some are designed to ensure that those working in the lending industry have sufficient education and ethical principles to work with the public.

Other laws and regulations have been put in place to require certain disclosures are made to consumers so that they may make informed buying decisions. The most sweeping of these laws is the "Dodd-Frank Act," which took effect on April 1 this year. 

Some of the most highly touted elements of this consumer protection legislation has to do with how loan originators are paid. Loan officers are no longer paid based on the the terms of the loan. This means that loan officers no longer have any incentive to up-sell a rate in order to increase his or her income. In itself, this isn't a bad thing. 

However, the lesser-known implication of Dodd-Frank has to do with the protection of banks. The act stipulates that banks must verify income. This is Section 1411, also called the “Ability to Repay” section of the law.

This means that the “stated” income programs simply no longer exist.

However, what is not well advertised is the ulterior motive of this entire piece of legislation. Buried deep at the end of the law is one clause, seemingly unrelated to the section in which it sits, is the following clause:

A creditor making a residential mortgage loan shall verify amounts of income or assets that such creditor relies on to determine repayment ability, including expected income or assets, by reviewing the consumer’s Internal Revenue Service Form W–2, tax returns … (Sec 1411,§ 129C (a)(4)

It seems that with one strike of a pen, the federal government has now made every loan underwriter an arm of the IRS. How, one might ask? Let’s look at two  examples:

• First is the typical, self-employed person who makes use of legitimate and legal deductions in order to reduce his or her tax burden. In taking deductions, the borrower reduces what the underwriter is permitted to count towards “effective” income. So, now, the self-employed need to consider not taking legitimate deductions, if they believe that they will need to take out a loan in the near future. What is more, the guidelines require two, and sometimes, three years’ tax returns that will be averaged and the Adjusted Gross Income (AGI) will determine the income able to be calculated in the debt-to-income (DTI) ratios.

• Next are those who either rent out rooms or own investment properties which are rented. Unless the landlord reports all the rental income on Schedule E, all the costs of the rental must be counted against them, but none of the income can be calculated to offset those costs (mortgages, repairs, etc.). In fact, it’s even worse than that. If there are repair items on the Schedule E, even if they are one-time expenses such as a new roof, or HVAC system or the like, that repair cost is assumed to be a continuing cost and will reduce effective income. 

Obviously, these two examples are not exhaustive, but prove a point. Unless applicants claim all income, and accepts that they may not take even legitimate deductions, they may not qualify for a loan, even if they clearly and verifiably do make sufficient income. 

For banks, because of Dodd-Frank, if it’s not on your taxes, it doesn’t exist.

This, of course, was the ulterior goal of the writers of the legislation. They didn't have the courage to try to raise taxes, so they took the back door. Rather, they raised tax revenue not publicly, but by making it virtually impossible to utilize even legitimate tax shelters by making tax returns the only legal proof of income for a “Qualified Mortgage.” 

Fewer deductions being claimed means more tax dollars into the IRS.

This new process makes it illegal to verify rental income by showing canceled checks and rental agreements means more private landlords reporting rental income means more tax dollars for the IRS. You get the point. 

So, effectively, your underwriter becomes a pseudo-agent of the IRS, at least if you want to get a loan.