Tax Transcripts and Their Value in Lending Transactions Part 1

What this is: An IRS tax transcript provides a summary of tax return information and is an integral part of the lending process. It verifies a borrower’s sources of income and helps lenders make informed and fair lending decisions. Considered the blueprint of a tax return, tax transcripts include most line items from the return, along with any accompanying forms and schedules. The IRS offers several types of transcripts, each serving a distinct purpose.  

What this means: In this article, we will delve deeper into IRS tax transcripts, explore their role in a lender’s due diligence, explain how they can be obtained and what mishaps to avoid. 

What is a Tax Transcript? 

A tax transcript is used to assist underwriters in verifying a borrower’s sources of income and typically includes taxpayer information (name and Social Security number), filing status, adjusted gross income, taxable income, tax liability, credits, payments and account details. Transcripts report sources of income shown on a given tax return, such as wages, tips, self-employment income and retirement income. Most tax transcripts are available for the current year and the previous 3 years.  

What Different Types of Tax Transcripts Can Be Obtained? 

• Tax Return Transcript: Summarizes the lines entered on the original tax return. 
• Tax Account Transcript: Here you will find the filing status and adjusted gross income. 
• Record of Account Transcript: A combination of the previous 2. 
• Wage and Income Transcript: Shows only the income section of the return. 

Tax Transcript vs. Tax Return: What’s the Difference? 

A tax transcript and a tax return are both documents related to a tax filing, but they serve different purposes and contain different information. A tax return is the comprehensive document filed, while a tax transcript is a summarized version of that information, used for verification and other business purposes. 

Lenders or financial institutions can request a tax transcript on behalf of a taxpayer. To obtain the taxpayer’s consent, the taxpayer must sign IRS Form 4506-C or Form 8821 authorizing a third party to obtain tax transcripts for purposes such as loan underwriting, income verification and financial assessment. The form is submitted to the IRS for processing and if prepared correctly, the IRS returns the requested transcripts to the third party. 

The Importance of Tax Transcripts in Lending 

Because of their presumed accuracy and official status, tax transcripts are widely accepted by lenders and financial institutions to fulfill their requirements for the following: 

Income Verification  

Lenders use tax transcripts to verify the income reported by borrowers on their loan applications and to identify any discrepancies between the income reported on loan applications and the income filed with the IRS. 

Assessment of Financial Health   

Tax transcripts provide comprehensive information about a borrower’s income, which is essential for calculating the debt-to-income ratio. They offer a historical view of the borrower’s income over several years. 

Confirmation of Tax Compliance   

Lenders need to ensure that borrowers are in compliance with tax obligations. Knowing that a borrower is compliant with tax filings reduces the risk for lenders, as tax non-compliance can be a red flag for financial irresponsibility. 

Fraud Prevention   

Tax transcripts help verify the identity of the borrower, reducing the risk of fraud. They can reveal inconsistencies or false information provided by borrowers, such as inflated income figures. 

Regulatory Compliance  

By verifying income and financial information accurately, tax transcripts help lenders adhere to federal and state regulations, protect consumers and maintain the integrity of the lending process. 

Types of Lending Transactions That Require Tax Transcripts 

Tax transcripts are typically required in several types of lending transactions to verify income and to assess the borrower’s ability to repay the loan. For example, a crucial step of underwriting and closing an SBA loan is verification of the SBA applicant’s financial information and tax returns. Standard Operating Procedure (SOP) 50 10 7.1 sets forth specific tax verification guidance and requirements at pages 72-74.  

The Small Business Administration (SBA) requires that SBA lenders verify financial information to:  

1.  Confirm that the applicant filed business tax returns and 
2. Verify that the applicant’s financial statements that were provided to the lender match the tax returns that were filed with the IRS.  

In addition to SBA lending, the following types of lending transactions often require tax transcripts: 

• Mortgage loans
• Home equity loans and lines of credit (HELOCs)
• Refinancing loans
• Personal loans
• Commercial loans
• Debt consolidation loans
• Investment property loans 

Why Are Tax Transcripts Important in the Loan Approval Process? 

The impact of tax transcripts on the loan approval process is substantial. They provide critical verification of income, help prevent fraud, promote regulatory compliance and contribute to a faster and more efficient loan processing experience. Accurate and verified financial information through tax transcripts leads to more informed lending decisions, better risk management and appropriate loan terms and amounts tailored to the borrower’s financial resources. 

Challenges and Limitations 

Availability Varies 

The availability of a tax transcript for the current year Form 1040 return filed on or before the April due date varies based on the method used to file the return and whether there is a refund or balance due. Tax transcripts can be requested anywhere from 2-8 weeks after the return has been submitted. Tax transcripts for previous years can be ordered at any time. The processing time for IRS Form 4506-C varies; however normal processing time is within 3-5 business days if the form has been completed correctly. 

Form 4506-C Commonly Faces Rejection 

It is important that all information on Form 4506-C is reviewed for accuracy to avoid rejections which impact processing times. It is common for the 4506-C form to face rejections from the IRS. Because borrower data on the form is non-public information, the IRS aggressively reviews all lender-completed fields to prevent unauthorized access to taxpayer information. Be on the lookout for missing signatures, omitted tax year information, missing information such as name and address, boxes left unchecked, forms that appear manually altered and/or inconsistent dates or a signature date that is 120 days outside of the IRS request window. 

The accuracy of a tax transcript is related to the accuracy of the tax return filed. If there were any errors or omissions in the original tax return, these would be reflected in the transcript.  

Potential Discrepancies 

Potential discrepancies can arise when there is a timing difference (when income is earned and when it is reported), unreported income, errors in reporting, amended returns, adjustments by the IRS, fraudulent activity and/or deductions and credits. 

Privacy and Data Security Concerns 

Tax transcripts contain sensitive information and there are several privacy concerns and data security issues associated with them. Concerns include unauthorized access if a transcript is not securely stored, phishing scams by individuals who pose as an IRS representative to trick taxpayers into sharing the transcripts, inadequate encryption when tax transcripts are transmitted electronically and/or malware and cyberattacks on systems where tax transcripts are stored. 

To mitigate these risks, it’s important to use secure methods for storing and transmitting tax transcripts, implement strong encryption for electronic data, train employees on proper handling and disposal of sensitive documents, regularly update security measures to protect against evolving threats and verify the identity of individuals and entities requesting access to tax transcripts. 

Conclusion 

Tax transcripts are critical in the lending process. By obtaining tax transcripts to verify income, assess financial stability, detect fraud and comply with lending regulations, lenders are provided a reliable and comprehensive view of a borrower’s financial situation. 

Not only do tax transcripts provide a means for a lender to make informed decisions based on a true understanding of a borrower’s ability to repay, but they also promote transparency and accuracy in upholding fair lending practices. This piece of a lender’s financial documentation ensures that all borrowers are assessed based on consistent and truthful information, promoting fairness and equality in the lending process.  

An experienced service company can help lenders swiftly validate income and detect potential borrower misrepresentations by obtaining electronic tax transcripts from the IRS.

Watch for Part 2 of this series to learn more about IRS Form 8821 and how it enables lenders to verify identities and obtain additional borrower information directly from the IRS. With a borrower’s signature, IRS Form 8821 not only provides tax transcripts, but it provides insight into a borrower’s unpaid federal tax debt.

This article is provided for informational purposes only and should not be considered, or relied upon, as legal advice.