Making a case for the inclusion of foreign income that is not subject to U.S. tax
- Facts and editorial/opinion

BACKGROUND:
One of the two borrowers works in Dubai and gets paid in a foreign currency.  That currency is pegged to the US dollar, so there can not be any fluctuations in value.  However, this loan was denied by another lender because of the fact that the borrower was paid in a foreign currency.   The guidelines don’t mention this issue.
UNDERWRITER:
Borrowers must earn income in US dollars and report US taxable income. If the borrower is paid in foreign currency, those checks are only cashed in foreign currency and not US dollars, therefore making the income ineligible.
Dubai currency pegged to US dollars is really not any different than Euros or the Mexican peso – it is just pegged at an exchange rate. Has nothing to do with the taxability of the earnings by the IRS.

MORE BACKGROUND:
Borrower is a US citizen and files US taxes reporting everything she earns overseas.  Much of that is not taxable under US tax laws but it all gets reported to Uncle Sam.  Also, the difference b/t a currency being pegged to the US dollar verses something else, like the Euro for example, is that a currency fluctuation will never change the borrower’s actual earnings.  For example, if the borrower makes the equivalent of $50,000 US dollars then even if the value of the dollar increases, if that foreign currency is pegged to the US dollar, our borrower still makes $50,000 US dollars.  If that currency were the Euro, then that $50,000 turns into something less as the dollar increases in value relative to the Euro.  Similarly the Euro could decline in value against the dollar, this would also reduce the borrowers actual earnings – that can’t happen if the currency is pegged to the Dollar.    I’m not sure if any of this makes any difference for purposes of FHA insurance, I just thought it to be a substantial distinction.
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UNDERWRITER:
Income for qualifying purposes must be taxable and be part of the AGI on a persons’ tax return. Paying taxes on US income is fundamental to the nature of  Federally insured FHA mortgages.  The section below provides examples of allowable income. You will NOT see any exception to “add back” non taxable compensation. As for the currency exchange issue, I understand the Dubai $ is fixed to the  US dollar as opposed to the Euro, etc . But  it is still not relevant to US taxable income.Income must be taxable in the US and not just reported as foreign earnings on a supplemental schedule on a tax return. Think of it as a borrower making “off the books”  income or illegal income. It cannot be used if no taxes are paid on it.
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4155.1 REV-5 business shows a significant decline in income over the period analyzed is not acceptable, even if current income and debt ratios meet our guidelines. There are four basic types of business structures: sole proprietorships, corporations; limited liability (”S” corporations); and partnerships. Each type requires slightly different forms of analysis. The following provides additional information on analyzing tax returns: 1.
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Individual Tax Returns (IRS Form 1040). The amount shown on the IRS Form 1040 as “adjusted gross income” either must be increased or decreased, based on the lender’s analysis of the individual tax returns and any related tax schedules. Particular attention must be paid to the following: a. Wages, Salaries, and Tips. An amount shown under this heading may indicate that the individual is a salaried employee of a corporation or has other sources of income. It also may indicate that the spouse is employed, in which case the income must be subtracted from the adjusted gross income in the analysis. b. Business Income or Loss (from Schedule C). The sole proprietorship income calculated on Schedule C is business income. Depreciation or depletion may be added back to adjusted gross income. c. Rents, Royalties, Partnerships, Etc. (from Schedule E). Any income received from rental properties or royalties may be used as income after adding back any depreciation shown on Schedule E. d. Capital Gain or Loss (from Schedule D).
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This transaction generally occurs only one time, and it should not be considered in determining effective income. However, if the business has a constant turnover of assets resulting in gains or losses, the capital gain or loss may be considered in determining the income, provided the borrower has at least three years’ tax returns evidencing capital gains. An example includes an individual who purchases old houses, remodels them, and sells them for a profit. e. Interest and Dividend Income (from Schedule B). This income, which is taxable and tax-exempt, may be added back to the adjusted gross income only if it has been received for the past two years and is expected to continue.
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October 2003 2-21 4155.1 REV-5 (If the interest-bearing asset will be liquidated as a source of the cash investment, the lender must adjust accordingly.) f. Farm Income or Loss (from Schedule F). Any depreciation shown on Schedule F may be added back to the adjusted gross income. g. IRA Distributions, Pensions, Annuities, and Social Security Benefits. The non-taxable portion of these items may be added back to the adjusted gross income, if the income is expected to continue for the first three years of the mortgage. h. Adjustments to Income. Certain adjustments to income shown on the IRS Form 1040 may be added back to the adjusted gross income. Among these adjustments are IRA and Keogh retirement deductions, penalties on early withdrawal of savings, health insurance deductions, and alimony payments. i. Employee Business Expenses. These expenses are actual cash expenses that must be deducted from the borrower’s adjusted gross income.
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MAKING A CASE:
In two separate sections the FHA guidelines seem to specifically permit the inclusion of foreign income that is not subject to US tax. – the guidelines specifically provide for the grossing up of non-taxable income even in the case where the borrower is NOT required to file a US tax return.  See 4155.1 REV-5, 2-7Q, “Non taxable income” which provides, in pertinent part, “If a particular source of regular income is not subject to federal taxes… the amount of continuing tax savings attributable to the non-taxable income source may be added to the borrower’s gross income….  If the borrower is not required to file a federal income tax return, the tax rate to use is 25 percent.” 
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The FHA guidelines specifically state that non-taxable income should be grossed up by 25% even in the case where the borrower is not required to file a US tax return - I am not able to reconcile this with the rationale provided for excluding the prospective borrower from participation in an FHA insured mortgage.  How can this be true if “paying taxes on US income is fundamental to the nature of Federally insured mortgages”? I think FHA  fully intended participation to be open to US citizens regardless of whether their income is subject to US tax. 
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Would you permit a plaintiff in a court proceeding who received compensatory damages for the loss of a family member to be paid out in $50,000 increments annually over the next 20 years to use that $50,000 per year as qualifying income (lets assume that’s the borrowers only income)?  These compensatory damages are not subject to US tax, so the entire $50,000 per year is received tax free with no further US tax obligations (except of course that interest made from the money received would be taxable).  Would we try to exclude this borrower or his income because the $50,000 is not part of the borrowers Adjusted Gross Income?
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–the FHA guidelines make specific reference to the ability of US citizens residing in a foreign country to be a co-signer on an FHA loan.  In discussing co-borrower and co-signer eligibility, Section 2-2A3 states, “Unless otherwise exempted (e.g., military service with overseas assignments, US citizens living abroad), any non-occupying co-borrowers or con-signers must have a principal residence in the United States.”  The parenthetical makes specific reference to the ability of a US citizen living abroad to qualify as a non-occupying co-borrower.  The only way to interpret this rule is acknowledge that a co-borrower living abroad need not have a permanent residence in the US – however one defines “permanent residence” (that is, of course, irrelevant to the issue being considered).  Should our borrower be penalized for taking advantage of a favorable tax rule?
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–Discriminatory consequences based on income levels:  The exclusion applicable to income earned by US citizens living abroad applies only to the first $85,700 – amounts in excess of the $85,700 are fully taxable in the US.  If a borrower makes $200,000 per year, and therefore pays US tax on income that exceeds the 85,700 exclusion, can that person then be a co-signor on an FHA loan because US tax has been paid? I don’t think we can have two different answers for two similarly situated US citizens working and living abroad based on their relative income levels, one answer for the prospective borrower making $50,000 per year and a different and more favorable answer for the borrower making $200,000 per year.  I don’t think that is a distinction HUD would or should be comfortable with.
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–IRS Regulations:  The Tax Code and IRS Regulations don’t support discrimination against US citizens based merely on the exclusion of certain foreign income from taxation.   The first paragraph of the instructions to Form 2555 (exclusion of foreign earned income, link attached http://www.irs.gov/pub/irs-pdf/i2555.pdf ) states the following, “If you are a US citizen or a US resident living in a foreign country, you are subject to the same U.S. income tax laws that apply to citizens and resident aliens living in the US.  But, if you qualify, use Form 2555 to exclude a limited amount of your foreign earned income…”  A US citizen who elects to exclude foreign earned income is for all other purposes treated as a US citizen subject to all other US tax laws.  In fact, if that same taxpayer has income from other sources, when determining the appropriate tax bracket for that ”other income”, the taxpayer must pretend that the excluded foreign income was in fact received, and is therefore taxed at a higher rate on that ”other income”.
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–Exclusion is entirely elective:  The election to exclude the foreign income is entirely elective, it IS NOT mandatory nor is it otherwise required (see “Choosing The Elections” on instructions to Form 2555, link above).  If a taxpayer does not elect to exclude the first $85,700 of foreign income from US taxation, does that taxpayer then qualify for FHA financing (as a non-occupant co-borrower) because US tax has been paid (assume for the sake of argument that total income is $50,000 US dollars in foreign currency)?  If so, should there be a difference between the US citizen who elects to take advantage of a favorable tax law and the one who does not?  I think the answer has to be no, as it would otherwise be tantamount to rewarding someone for their stupidity.   
Contact me to discuss the above or your own loan details
Mark Zaidan, Choice Finance®