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Tax Reform Opportunities for the Independent Mortgage Banker

Tax Reform Opportunities for the Independent Mortgage Banker

The Tax Cuts and Jobs Act, often referred to simply as “tax reform” and herein as the “Act,” received a great deal of attention as it sped its way through Congress and into law. This article looks at a few general and specific provisions of the law that directly impact the independent mortgage banker.

Effective Tax Rates for the Independent Mortgage Banker

Most likely every business owner is aware of the new flat tax rate of 21% (from a high of 35% in prior law) applicable to C corporation earnings beginning in 2018. The new top tax rate now applicable to individuals is 37% (down from a high of 39.6%), which impacts individuals with flow-through income from a business. This new tax rate for individuals is complimented by the Qualified Business Income (“QBI”) deduction, a deduction equal to 20% of the QBI, which is available to owners of “pass-through” entities such as partnerships, S corporations and sole proprietorships. However, there is bad news for mortgage banks doing business as a pass-through entity. The Act did not provide all the necessary details, however, our initial interpretation leads us to believe that a mortgage bank will not meet the definition of a qualified trade or business and thus will not receive the benefit of the 20% QBI deduction. We expect the IRS to issue guidance in this area later this year. This disqualification from the 20% deduction, coupled with the mortgage banks likely incentive to retain profits in the company to comply with regulatory and lender net worth requirements, raises the question – Is it time to convert to from pass-through status to C corporation status? This is not a change to be made lightly. The decision-making process is complex and must take into account a number of factors, some of which include:

  • Current and projected growth and profitability
  • Intentions regarding distributions of profits
  • Longer term exit strategies and intentions
  • State and local tax implications
  • Other income and deductions on the individuals’ returns
  • Compliance with banking regulations
  • And much, much more

Interest Expense Deduction

Under the Act the deduction of net interest expense (business interest expense less business interest income) is limited to 30% of the taxpayer’s adjusted taxable income. Adjusted taxable income for these purposes means taxable income from the business computed without regard to 1) non-trade or business income or deductions, 2) interest income or expense, 3) net operating loss deductions, 4) qualified business income deduction, 5) depreciation, amortization or depletion (for tax years beginning before January 1, 2022). If the company is experiencing a year of low profitability, it could lose the benefit of this deduction in the current year. Note, however, that unused interest deductions can be carried forward indefinitely. The table below shows four examples of how the limitation would apply.

Interest income from borrowers Interest expense to warehouse lenders Net interest income (expense) Adjusted taxable income Interest limitation (at 30% + interest income) Allowable interest deduction Interest deduction disallowed / carryforward
 Example 1            100,000             90,000          10,000        200,000            160,000        90,000  N/A
 Example 2            100,000          120,000        (20,000)        200,000            160,000      120,000  N/A
 Example 3            100,000          120,000        (20,000)           50,000            115,000      115,000              5,000
 Example 4              90,000          115,000        (25,000)           50,000            105,000      105,000           10,000

Note that there are exemptions from this limitation for certain industries (not mortgage banking) and additional limitations related to partnerships to prevent a double benefit from the deduction. Taxpayers with average annual gross receipts that do not exceed $25 million (determined after applying the “aggregation rules” that capture controlled groups of corporations) are exempt from this limitation.

Mortgage Servicing Rights – No Change!

While the original version of the Senate bill required taxpayers with an applicable financial statement to recognize revenue on a GAAP basis for income tax purposes, the final version of the Senate bill included an exception for any item of gross income in connection with a mortgage servicing contract. Thus income from mortgage servicing rights will continue to be recognized in accordance with the prior law for such items of gross income. Therefore, “normal” mortgage servicing rights will be included in income upon the earlier of earned or received under the all events test of I.R.C. Section 451 (i.e., not averaged over the life of the mortgage), and “excess” mortgage servicing rights will be treated as stripped coupons under I.R.C. Section 1286 and subject to the original issue discount rules.

Meals and Entertainment

Significant changes were made to an employers’ ability to deduct meal and entertainment expenses. Business-related meals remain subject to the 50% limitation on deductibility, and the act expanded the 50% limitation to meals provided for the convenience of the employer (previously 100% deductible). Looking further out, after 2025 these expenses become fully non-deductible. Further, all entertainment expenses (e.g., golf outings, fishing, sailing, sporting events, hunting, theater tickets, license fees paid to sporting arenas, golf club dues, etc.) are now fully non-deductible even if business was discussed or conducted. Finally, deductions for employee qualified transportation fringe benefits (i.e., parking and mass transit) will no longer be permitted under the Act, however, such expenditures on behalf of employees will continue to be excluded from the employee’s taxable income.

Conclusion

These and many other provisions of the Act could have a significant impact on the independent mortgage banker. Please contact a Withum professional to discuss the potential tax savings opportunities available to you, or fill out the form and we’ll reach out to you.

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