Why lenders request tax returns

Lenders ask for tax returns because they are a verified, detailed record of income, expenses, and tax treatments that can’t be fully seen from a credit report or a bank statement alone. Underwriters use returns to verify the numbers you put on the loan application and to look for trends, one‑time items, or tax adjustments that change qualifying income (IRS: About Form 1040).

What specific items they review

  • Adjusted gross income (AGI) and taxable income — baseline for many underwriting calculations.
  • W‑2 wages and 1099 miscellaneous/self‑employment income — confirms earned income sources.
  • Schedule C (sole proprietors) — net profit or loss; lenders often average two years and may add back depreciation or one‑time expenses when assessing qualifying income.
  • Schedule E (rental income) — rental profit/loss and any passive loss limitations.
  • K‑1s (partnerships, S corporations, trusts) — pass‑through income or losses that affect cash flow.
  • Depreciation, non‑cash losses, and large one‑time deductions — may be added back if underwriter determines they don’t reflect true cash flow.
  • Capital gains, dividends, and interest — treated differently depending on stability and tax treatment.
  • Carryover losses, net operating losses (NOL), and business loss patterns — repeated losses can reduce qualifying income.
  • Unreported income flags — inconsistencies between reported income and 1099/W‑2 information can trigger verification or denial (see how the IRS cross‑checks information returns).

How lenders use returns in underwriting

  • Income verification and stability: Most mortgage and business lenders ask for 2 years of personal and business returns to confirm steady income; some programs look back 3 years for self‑employed borrowers.
  • Debt‑to‑income (DTI): Taxable income and documented debts feed the DTI ratio used to qualify you for specific loan tiers.
  • Calculating qualifying income: Lenders may adjust tax‑return figures (add‑backs for depreciation, subtract large nonrecurring income) to arrive at a monthly qualifying income.
  • Fraud prevention and verification: Lenders commonly request IRS transcripts via Form 4506‑T to directly verify filed returns with the IRS.

Sources: IRS (About Form 1040); Consumer Financial Protection Bureau (general underwriting guidance).

Common red flags lenders look for

  • Large year‑to‑year swings in income without explanation.
  • Repeated business losses on Schedule C or K‑1s.
  • Inconsistencies between W‑2/1099s and reported income.
  • Undocumented rental income claimed on Schedule E without leases or bank statements.
  • Unfiled returns or amended returns that create unclear history (see consequences of unfiled tax returns).

Documents lenders may also request

  • IRS tax transcripts (via Form 4506‑T).
  • Business profit & loss statements and balance sheets, especially for self‑employed applicants.
  • Bank statements to prove deposits and cash flow.
  • Copies of leases, K‑1 support, and explanations for any large or unusual items on returns.

Practical tips to prepare (professional guidance)

  1. File timely, accurate returns: Errors or late filings delay underwriting — if you have unfiled years, resolve them early (see our guide on unfiled returns).
  2. Prepare a clear package if self‑employed: Provide signed returns plus year‑to‑date P&L and a CPA letter that explains add‑backs or one‑time expenses.
  3. Explain one‑time items: Add a short, signed explanation for any large capital gains, losses, or nonrecurring income.
  4. Avoid making major tax‑reducing moves right before applying: Excessive write‑offs or business losses in the most recent year can lower qualifying income.
  5. Work with a CPA or mortgage professional: In my practice, a preparer’s explanation for depreciation add‑backs or for a temporary business dip often moves a file from manual review to approval.

Short FAQs

  • How many years of returns do lenders need? Typically 2 years for most consumer loans; 2–3 years for self‑employed borrowers depending on program.
  • Will lenders look at amended returns? Yes — amended returns are reviewed and may trigger requests for explanations or IRS transcripts.
  • Can tax deductions hurt my loan chances? Large or recurring deductions that reduce taxable income can lower qualifying income; lenders will want context and supporting docs.

Internal resources

Disclaimer

This article is educational and not individualized tax or lending advice. Rules vary by lender and loan program; consult a CPA or loan officer about your specific situation.