To Gross Up or not to Gross Up Non-Taxable Income

Not treating all the same can cause fair lending issues. As you know the buying power of tax free income is substantially greater than taxable income, and the applicant should get credit for the increased purchasing abilities.

I forget the bank (many years ago), but they were criticized by the regulators for only grossing up non-taxable income when the need came up. If the applicant met the income (DTI) requirements, they did nothing else. If they did not meet the income requirements then they would gross up non-taxable income, if any. Regulators indicated the bank was inconsistent in application of underwriting.

One issue may be for consistency. What if the pricing in part was based on debt to income? By not grossing up some incomes, it may mean the borrower paid a higher price for the loan.

Example: In the past, lenders primarily considered net income in making underwriting decisions. In recent years, the trend has been to consider gross income. A lender decided to switch its practices to consider gross income rather than net income. However, in calculating gross income, the lender did not distinguish between taxable and nontaxable income even though nontaxable income is of more value than the equivalent amount of taxable income. The lender's policy may have a disparate impact on individuals with disabilities and the elderly, both of whom are more likely than the general applicant pool to receive substantial nontaxable income. The lender's policy is likely to be proven discriminatory. First, the lender is unlikely to be able to show that the policy is compelled by business necessity. Second, even if the lender could show business necessity, the lender could achieve the same purpose with less discriminatory effect by "grossing up" nontaxable income (i.e., making it equivalent to gross taxable income by using formulas related to the applicant's tax bracket).