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MONTHLY TAX NEWSLETTERSeptember 2009
Sir Isaac Newton was definitely a man ahead of his time. One could even say he accurately predicted today's mortgage market by stating, "To every action there is always opposed an equal reaction".
Just a few years back, getting a mortgage was ridiculously easy. No income verification loans providing 100% financing somehow became the norm.
Today, the mortgage market has reacted to those carefree days, and obtaining a mortgage has become much more of a challenge. For starters, Bank of America discontinued their successful Doctor Loan Program back in March. No longer would B of A provide mortgages allowing doctors to borrow up to 100% of the cost of a home at a competitive interest rate with no Private Mortgage Insurance (PMI).
Based on my recent experiences working with clients trying to obtain a mortgage, lenders have replaced under-underwriting from a few years back with a new paradigm of over-underwriting. In other word, mortgage underwriting has now become significantly more rigorous. Let's look at a few examples of today's over-underwriting.
One of my clients who has a seven figure investment portfolio was trying to obtain a $600k mortgage. This client doesn't have much other debt, and earns a good salary from a business he owns. Well, I ended up speaking with three different employees of the mortgage company's underwriting department at least a half dozen times trying to help my client obtain his mortgage. I even got calls over the weekend from the underwriting team. Finally, I spoke to a manager to clarify one final question on my client's 2008 tax return, and was told that my client would have been denied his mortgage if I hadn't been able to clarify that one number on his tax return - even though this client could have liquidated a portion of his investment portfolio and paid cash for the home.
Around the same time, I was also helping another client who was trying to obtain a mortgage for a primary residence. This client is two married MDs who both earn a good living. One has a private practice, however, so the underwriters asked me to prepare a Profit and Loss Statement that included his collections and professional expenses for the prior year as well as for the first five months of 2009. Preparing this report is fairly standard and is no big deal, so my office promptly prepared and forwarded the Profit and Loss Statement to the underwriters. Well, a few weeks later, we were asked to update the report to reflect his collections and expenses for the first SIX months of the year. Now really, how much could things change in one month for an established psychiatrist? That's what I call over-underwriting!
After commenting about my recent experiences with the new mortgage underwriting standards to my #1 mortgage resource Bob Cahill , Senior Mortgage Loan Officer at Bank of America licensed in all fifty states (Click to e-mail Bob), he explained to me, "People who deserve a mortgage are still getting a loan. Yes, the documentation process is more challenging. So let your clients know that they need to plan ahead!"
Bob points out that mortgages are still available to people who aren't able to come up with a down payment of 20% on their own. "In addition to FHA/VA and special local bond programs, these options include Conforming loans (up to $417k) to 95% and the temporary stimulus Super Conforming loans to 90% (see below for loan size limits). However, in the current declining housing market, these limits might be reduced by 5% to 90% and 85% respectively. Jumbos or Non-Conforming mortgages now require a 20% down payment."
"Gifts are a common solution for down payment. However, 5% of the down payment must come from the borrower's funds if the total down payment is less than 20%. Since sourcing of funds to cover a down payment, closing costs and reserves only requires a 60 day history, planning ahead and depositing large gifts or other assets into your bank account at least 60 days prior to applying for a loan can greatly simplify and ease your qualification as these assets would now be considered your assets and not a gift."
When asked how one's credit score impacts the loan underwriting process, Bob explains, "People with a credit score of 660 who have enough money for a 20% down payment are still able to get a Conforming mortgage, however at a higher interest rate. A Super Conforming loan requires a 700 credit score unless you have 25% to put down which then would lower the score requirement also to 660. FHA may offer a better option and offer a lower interest rate and monthly cost if your credit score comes in below 680. FHA allows credit scores as low as 600 with smaller rate penalties provided recent credit history is good enough to qualify."
Even so, taking steps to increase your credit score will definitely save you a lot of money over the life of the mortgage. "Expect your mortgage interest rate to be based on your credit score unless you’re using FHA/VA or special first time buyer bond programs. Your interest rate for a conventional loan will be up to one-half of a percent better if your credit score comes in at 740 instead of 680."
Bob's final piece of advice to people thinking about purchasing or refinancing a home, "Reach out to a Loan Officer earlier. Someone who knows the mortgage market can help you do some table setting to get yourself in a much better position in the eyes of a potential lender."
How much of a mortgage can you afford to carry? During the hey day of overly generous lending from earlier this decade, you could obtain a Conforming mortgage that would bring your total monthly costs to as high as 65% of your monthly income. That means on a salary of $600k per year, you could allocate $3,250 per month towards your total debt inclusive of housing costs. Even if real estate taxes and other total debt ran at $1,000 per month, you would have been able to qualify for a mortgage of as high as $400k. Jumbo or Non-Conforming debt to income ratios have also been curtailed from the highs of 50%.
Now, lenders are capping the loans they write so your monthly housing costs are more in line with where they probably should have been all along. Currently, for a Conforming loan, while total debt ratios shouldn’t exceed 36%, of your gross income, they might go as high as 45% with strong compensating factors such as high credit score, strong down payment and good reserves. Jumbo or Non-Conforming loan total debt ratios are now limited to 45% of your income. However, Bob expects that these limits may be reduced further if Jumbo defaults continue to escalate. While these changes reduce the amount you can borrow by as much as 40%, they should protect you and the lenders over the long haul.
When getting a mortgage, Bob explained that the first issue to understand is the type of mortgage you will get is a function of the amount of money you are borrowing, as follows:
Bob also gave me a brief description of the loan options available these days for home purchases as well as for refinancing:
Sir Isaac Newton once said, "If I have ever made any valuable discoveries, it has been owing more to patient attention, than to any other talent." My realization that the mortgage industry now seems to be over-underwriting is also the result of nothing more scientific than patient attention to recent interactions with my clients' lenders.
As you have probably read, UBS is in the process of handing over to the US Government information on foreign investment accounts for close to five thousand individuals. It appears that the IRS is using this event to prompt taxpayers to voluntarily pay income taxes on previously unreported investment earnings within their foreign accounts.
To avoid being hit with substantial penalties, you have through September 23rd to file Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts, and to amend your income tax returns back to 2003 to report income earned on any undisclosed foreign accounts.
The decision to purchase a medical or dental practice will rank as one of the largest that you will make in your lifetime. Not only are you providing for your income over the next 20 plus years, but you are also depending on this practice to secure you with a nest egg for your retirement.
Therefore, when buying a practice, healthcare professionals are advised to "Do their Due Diligence”, but often they are not quite sure of the actual meaning of that term, nor of the work involved. Essentially, this term refers to “doing your homework” – examining the finances, management and operations of a practice before making a final decision on purchasing the practice.
Remember, don’t lose sight of what you are buying. We all want new, state of the art equipment and a fancy waiting room. But those items can be addressed down the road, as long as the current equipment functions to meet your needs of practicing medicine or dentistry. You must realize that the most valuable asset you are buying is Goodwill – the intangible value of the seller’s practice mainly comprised of the seller’s existing patient base as well as the practice’s location. These two items are the main factors that drive the revenues of the practice.
Therefore, the importance of reviewing the existing patient files should not be overlooked. Conduct a Chart Audit to determine either the number of active patients in the practice or the demographics of the other providers who routinely refer patients to the practice.
For many practices, an active patient is one who has visited the practice for treatment within the last 12 months. Make sure to also review patient files for those patients that have not been seen within the past year but have visited for treatment within 2-3 years as there is potential to reactivate these patients and generate increased revenues.
While conducting your Chart Audit, take note of the specific work being performed on the patients. Are some of the procedures being done by the seller beyond your scope of practice? If so, your income from the practice may decrease once it is purchased as this work would need to be referred to a specialist. Or is the opposite true; is the seller referring work out to specialists that you may be able to do as part of your practice, resulting in a potential increase to your revenues.
You should plan a site visit to familiarize yourself with the day to day operations of the practice. Be aware of the culture of the practice. Is the staff courteous to the patients? Do all the staff get along or are there personality conflicts. Make sure that this office presents the right environment for you to work in and for you to manage. Additionally, take note of the age and functionality of the equipment. Will items need to be replaced soon after your purchase of the practice, and if so, at what potential cost?
As noted above, part of the goodwill of the practice is comprised of the office’s location. Therefore, be sure to inquire as to when the current lease of the office space expires, if there is an option to renew and, if so, then for how long of a term. Also inquire whether the current lease transfers to a new owner. If the landlord decides to sell the space in the future, will you have a right of first refusal to purchase the property? You should have an attorney familiar with real estate leases and contracts involved with this part of your due diligence process.
Finally, make sure you can afford this practice. Work with a CPA or other professional to calculate the cash flow of the practice. Determine the practice’s income that remains not only after paying all of the practice’s operating expenses, but also after making your debt payment and paying taxes. The net income of the seller’s practice per his tax return is not the equivalent pre-tax cash flow to you once you factor in the monthly debt payment required. Frequently practice loans are paid back over a seven year period making the annual debt payment substantial. As an example, borrowing $500,000 over seven years at 8% results in an annual payment of $93,500 - or almost $8,000 per month.
In conclusion, when buying a medical or dental practice, what you see is not always what you get. Thus, the key to making a successful transition from employee to owner is to for you to get an understanding of the practice’s revenues, expenses, patient base, and operations by Doing your Due Diligence.
Richard S Schwartz, CPA, CVA, received a B.A. in Economics from Brandeis University in 1985 and an M.S. in Accounting from the Graduate School of Professional Accounting at Northeastern University in 1990. Prior to joining his brother at Schwartz and Schwartz, P.C. in 1993, he worked for the international accounting firm PricewaterhouseCoopers, LLP, in their Emerging Business Services Group. Since joining Schwartz and Schwartz, P.C. he has worked with individuals providing tax expertise as well as small business owners providing both tax and accounting guidance to help their businesses grow. In 2006, Rick earned the designation of Certified Valuation Analyst from the National Association of Certified Valuation Analysts (NACVA), which he uses to assist healthcare professionals in their evaluation of whether to purchase a practice.
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