Digging for Dollars: How Mortgage Lenders Qualify the Self-employed
By Linda Keith, CPA
Mortgage lenders take a different approach if they are working on a portfolio loan or one their company plans to sell on the secondary market.
A portfolio loan needs to perform, and you need to understand your company’s guidelines. A secondary-market loan needs to meet investor/lender criteria. Understanding FannieMae or other lender guidelines is key.
In a presentation I did for the Western Regional Mortgage Brokers Association, I juxtaposed my ‘digging for dollars’ approach to tax return analysis to the FannieMae guidelines.
The 1084 FNMA form for Cashflow Analysis of Tax Returns gives us many opportunities to dig for dollars. In the column on the right below I have reproduced the FNMA instructions, as pulled from Allregs.com with their permission. (www. Allregs.com is a resource for mortgage guides online.)
My comments on the left are keyed to these instructions. Any Form 1040 line numbers I mention in my narrative apply to the current Tax Returns. Keep in mind that line numbers may vary from year to year on the returns.
(06/30/02) FNMA Form 1084 Instructions
Form 1040 — Individual Income Tax Return
Line 1 — Total Income: Begin with Total Income, which represents the borrower’s gross income before adjustments.
Line 2: Wages
Wherever you put the wages into cashflow, be sure you are using full gross wages. The figure on the tax return has been reduced for 401 K, Dependent Care Benefit and similar deductions. Get the pay-stub or W-2 (use Line 5) or whatever documentation you would use for a ‘regular’ wage earner to be sure you are giving this self-employed borrower full credit.
Line 2 — Wages, Salaries, Tips: Subtract any income reported on Form 1040 that has been verified and underwritten based on current information or that does not belong to the borrower. This type of income would include salary and hourly compensation, income from a spouse or ex-spouse that is not applying for mortgage credit, other income more appropriately underwritten based on current earnings rather than historical. Cross-reference the amount reported on Form 1040 against the amount indicated on the borrower’s Form W-2.
Line 3: Tax-exempt interest income
FNMA allows us to ‘gross up’ any continuing tax-exempt income when adding it to cashflow. This gets everything on a ‘taxable equivalent’ basis and allows our guidelines to work for all borrowers. The standard gross-up factor is 25%. (Multiply by 1.25). However, you can use a higher factor if the borrower’s tax bracket is higher. Instead of multiplying by 1.25, divide by 1-tax bracket. You’ll see that a 1.25 factor relates to a 20% tax bracket (1/.8=1.25).
So a borrower in a 39% bracket could have a factor of 1.65! (1-.39 = .61, 1/.61 = 1.65.)
Yes…this is more work than multiplying by 1.25. But when you are digging for dollars, this is just the type of insight you need to qualify your borrower.
Line 3 — Tax-exempt Interest Income: Add any tax-exempt interest income included on Form 1040 to the Total Income if it is likely to continue and is verified as recurring income. Taxable interest income and dividend income reported on Form 1040 will be addressed by analyzing Schedule B (Form 1040). This analysis should focus on the continuance of any interest or dividend income. (See analyzing Schedule B.)
[Excerpt regarding tax-exempt income from X, 402: Sources of Borrower’s Income (06/30/02)
A lender should give special consideration to regular sources of income that are nontaxable — such as child support payments, social security benefits, disability retirement payments, workers’ compensation benefits, certain types of public assistance payments, food stamps, etc. The lender must verify that the particular source of income is nontaxable and that both the income and its tax-exempt status are likely to continue. Documentation that can be used for this verification includes award letters, policy agreements, account statements, or any other documents that address the amount of income and the likelihood of its continuance for at least three years after the date of the loan application. (Nontaxable income status and the related tax savings can also be verified from IRS publications.) If the income is nontaxable and the income and its tax-exempt status are likely to continue, the lender may develop an “adjusted gross income” for the borrower by adding an amount equal to 25% of the nontaxable income to the borrower’s income. If the actual amount of federal and state taxes that would generally be paid by a wage earner in a similar tax bracket is more than 25% of the borrower’s nontaxable income, the lender may use that amount to develop the “adjusted gross income.” This adjusted gross income should be used in calculating the borrower’s qualifying ratio.]
Line 4 — State and local Tax Refunds: Subtract from Total Income all taxable refunds, credits, or offsets of state and local income taxes reported on Form 1040. A tax refund cannot be included as qualifying income since it has been accounted for in the previous year’s gross income.
Line 5 — Nonrecurring Alimony Received: Subtract from Total Income any alimony income that does not meet the following criteria:
• The receipt of alimony income had been documented as stable for at least 12 months,
• The payments will be ongoing and consistent with the level reported on Form 1040 for a minimum of three years, and
• The alimony payments are made as a result of a divorce decree or written and signed agreement that is a legal obligation.
Line 6 — Negate Schedule D (Income) Loss: Examine Schedule D (Form 1040) to determine whether capital gains should be added to or whether capital losses should be subtracted from Total Income. (See analyzing Schedule D.)
Line 7: PENSION Here is another ‘gross-up’ opportunity. See my notes for Line 2 Tax Exempt above.
Line 7 — Pension and/or IRA Distributions: The nontaxable portion of IRA distributions, pension, or annuity income is not included in Total Income reported on Form 1040. However, total distributions should be used as qualifying income provided the distributions are likely to continue for a minimum of three years and at their reported levels. Pension agreements or account verifications must be obtained to confirm the continuance of this income.
On Form 1040, total distributions are reported, however, only the taxable portion of total distributions is included in the borrower’s Total Income. To determine the tax-exempt portion of this income, calculate the difference between total distributions and the taxable portion and add the difference to Total Income by recording the calculated amount on Line 7 of our form. The tax-exempt portion of this income can be grossed up according to the guidelines that address tax-exempt income.
Line 8: SCHEDULE E
Don’t forget this step. Rentals often kick off paper losses. If you forget to add this back you’ll ding them twice on the rentals.
Line 8 — Negate Schedule E (Income) Loss: Negate all income (subtract) or loss (add) from rental real estate, royalties, partnerships, S corporations, and trusts. Each component of Schedule E (Form 1040) income (loss) reported on the first page of Form 1040 will be analyzed separately. This approach will help avoid complications that may arise if nondeductible losses occur.
Line 9 — Nonrecurring Unemployment Compensation: Nonrecurring unemployment compensation payments must be subtracted from Total Income. However, if it is typical for the borrower to be laid off seasonally (for example, a construction worker or landscape laborer) do not subtract the reported amount from Total Income. Unemployment compensation must appear in two consecutive years of tax returns and must be relatively consistent. In addition, the borrower’s current job must be subject to the same seasonally affected layoff. If these conditions do not exist, subtract the amount reported from Total Income.
Line 10: SOCIAL SECURITY
Another opportunity to ‘gross up’ excluded income. See my notes at Line 2. AND be aware that if their social security is not taxable, then it does not even have to be reported on the return. Loan originators and underwriters need to be watching the application for income sources, not just the tax return.
LINE 12 – OTHER
(Note the instructions do not mention a LINE 12 but there is one on the 1084.)
If the borrower has reported an NOL (Net Operating Loss) on Line 21 of their 1040, be sure to add this back here. NOLs are carryovers of previous losses and do not represent money spent this year.
WHEN NOL IS LARGE! … NOLs can significantly reduce taxes. A borrower with $50,000 in wages but a $40,000 NOL is only paying taxes on $10,000 of their wages, turning the other $40,000 into nontaxed income. And yet, our debt-to-income guidelines assume all income is taxable or is at a taxable equivalent!
If the NOL will continue to be substantial (see attached schedule at the end of the 1040 to see how much it was, how much was used and if the amount left will shelter significant amounts of income from taxes for at least three years), use this as a compensating factor in your write-up if you are close to qualifying but not quite there.
Line 10 — Social Security Benefits: Determine the difference between the total and the taxable social security benefits paid to the borrower and add the calculated amount to Total Income. In addition, deduct any nonrecurring taxable benefits. Supporting documentation must be obtained (statement of benefits) to confirm the continuance of this income. Scheduled benefit payments must continue for a minimum of three years to be considered as qualifying income. The tax-exempt portion of this income can be grossed up according to the guidelines that address tax-exempt income.
Line 11 — Nonrecurring Other (Income) Loss: Subtract other income from the borrower’s Total Income unless documentation can be obtained to verify that the receipt of the income will be consistent and ongoing (minimum of three years). Add back other losses to Total Income if documented to be nonrecurring .
Adjustments to Income: Form 1040 allows for the reduction in Total Income for items such as IRA contributions, moving expenses, various expenses associated with self-employment, and others. This worksheet begins with Total Income (Form 1040); therefore, an adjustment is not necessary for these items. Note however, that if the borrower is claiming an adjustment on Form 1040 for alimony paid, this obligation must be factored into the borrower’s monthly debt payments to calculate the total debt-to-income ratio.
Schedule A (Form 1040) — Itemized Deductions
A review of Schedule A will give the lender an indication of whether the borrower has owned real estate in the past and if there was a lien against a property (institutional or private). Interest paid on owner-occupied real estate and real estate taxes are itemized on Schedule A. Interest and real estate taxes paid on investment properties are reported on Schedule E (Supplemental Income and Loss). Unreimbursed employee expenses appear on Schedule A and indicate the borrower is subject to certain business expenses that must be factored in the analysis. The lender must obtain and examine Form 2106 if Schedule A indicates the presence of unreimbursed expenses.
Form 2106 — Employee Business Expenses
LINE 13 – Expenses
Compare the years to see if these expenses are really ongoing. There is a difference between an outside salesperson who has to pay for all of their travel and demo kits and an employee that took one course at a community college. Both are legitimately deductible but only one is required for the job and ongoing.
Line 13 — Total Expense: The borrower’s unreimbursed expenses are reported on Form 2106. Subtract the reported amount from Total Income. Note that when the borrower recognizes “actual expenses” rather than using the “standard mileage rate,” the lender must analyze the “actual expenses” section of the form checking for lease payments. Add back actual lease payments to ensure that the expense is recognized only once.
LINE 14 – DEPRECIATION
I am not sure where you are supposed to get the depreciation factor each year. I have most often seen lenders use 1/3rd of the standard mileage rate for the add-back.
Look for depreciation buried in Line 4 of the 2106 as well. They could be depreciating something other than vehicles.
Line 14 — Depreciation: If the borrower has claimed automobile depreciation on Form 2106, this expense should be added to the borrower’s income. Vehicle depreciation can be calculated one of two ways — by using the standard mileage deduction or actual depreciation expense. The method used by the borrower will be disclosed on the second page of Form 2106. If the borrower used the standard mileage deduction, multiply the business miles driven by the depreciation factor for the appropriate year and add the calculated amount to Total Income. If the borrower claimed the actual depreciation expense, add this amount to Total Income.
Schedule B (Form 1040) — Interest and Dividend Income
LINE 15 – INTEREST INCOME
This instruction refers you to Form 6252 to pick up the principal payment received if the contract is continuing. Since you will have to ask for the contract anyway to document that it is continuing more than three years, compare the interest on Schedule B plus the principal on 6252 to the total payments per the contract.
Some contracts have escalations and what may have been a $500/month payment in 2000 could be up to $600/month now. Consider using the current payment received.
Line 15 — Nonrecurring Interest Income: Subtract nonrecurring interest income from Total Income. This includes interest income from assets used to complete the subject transaction. Document the existence of the accounts on which the interest is earned and confirm that the balances have not significantly decreased. Subtract any interest income from seller financed mortgages that have less than three years remaining in the contract or that is unstable because of delinquent repayment. (Note that the principal portion of installment payments received is reported in Schedule D and Form 6252 [Installment Sale Income])
Line 16 — Nonrecurring Dividend Income: Document that the assets producing dividend income exist and are owned by the borrower. Deduct nonrecurring dividend income from Total Income.
Schedule C (Form 1040) — Profit or Loss from Business: Sole Proprietorship
LINE 17 – Other
As a tax preparer, I can tell you that this line is often used simply for another category of income. For example, a drug store might decide to put video rental income here.
Before you subtract it as nonrecurring, check the two years returns you have.
The narrative for Line 17 on the Form 1084 does not speak to nonrecurring expenses, but the heading does. Find these either by their name (moving expense) or by comparing two year’s. Repairs that jump dramatically might remind you there was a flood downtown and this business had unusual repairs.
Add back interest expense if the business loan has been paid off. Also, if there is interest expense on a Schedule C, check back to the borrower’s application and be sure you are not including business debt in with their personal debt.
Line 17 — Nonrecurring Other (Income) Loss/Expense: Other income reported on Schedule C represents income received that was not obtained from the profits of the business. Unless this income is documented and determined to be stable, consistent, and recurring, subtract all Other Income.
Line 18 — Depletion: Add back to Total Income any depletion reported on Schedule C.
LINE 19 – DEPRECIATION
Add back 1/3rd of Car and Truck Expenses (on Line 10 of the Schedule C) if the borrower used standard mileage. This is in addition to adding back any depreciation figure on Line 13 of the Schedule C.
Line 19 — Depreciation: Add back to Total Income any depreciation reported on Schedule C. Vehicle depreciation can be calculated one of two ways — by using the standard mileage deduction or actual depreciation expense. If the borrower used the standard mileage deduction, multiply the business miles driven by the depreciation factor for the appropriate year and add the calculated amount to the borrower’s cash flow.
LINE 20 – MEALS
Prior to 2005 returns, be careful to subtract Line 24c (the 1/2 disallowed), not line 24b (the full amount spent). 2005 returns, Line 24b is the amount to subtract.
Line 20 — Travel, Meals, and Entertainment: These expenses relate to the cost of business-related travel, meals, and entertainment and therefore the full amount of these expenses should be taken into account when determining the borrower’s actual cash flow. A portion of these expenses is excluded for meals and entertainment, subtract this exclusion from Total Income.
LINE 21 – HOME OFFICE
You’ll find this on Line 30 of Schedule C (Expenses for business use of your home), not Line 18 (Office Expense).
Line 21 — Business Use of Home: Add to Total Income any expenses for business use of home.
LINE 22 – AMORTIZATION
This expense, if it is on the Schedule C, will be listed on page two in Part V.
Line 22 — Amortization/Casualty Loss: Amortization expenses are usually one-time costs that are distributed over a period of time and can therefore be added to Total Income. Casualty losses are typically nonrecurring, add them to Total Income.
Schedule D (Form 1040) — Capital Gains and Losses
LINE 23 – GAINS/LOSSES
Consider if losses are on NONCASH lines. Any line that refers to ‘Schedule K-1’ or ‘Carryover’ is noncash.
Also, consider if the borrower is generating actual, recurring, positive cashflow from ‘losses’. A borrower who has built up stock or RE over the years and is selling it off in their retirement is generating the ‘proceeds’, not the gain/loss.
Example, a borrower bought stock for $50,000 ten years ago and sells it for $40,000 now. The tax return will show a loss of $10,000 but in cashflow terms, they received $40,000!!!
If capital losses will cause you to decline the loan, get the brokers statement to confirm they have not replaced the investments and they have net proceeds instead of a loss.
If your borrower is selling real estate, get the 1003 to show cash proceeds to seller. Often this will be higher than the gain since they may have paid down the original mortgage.
Note that we negated Schedule D gains or losses earlier. Evaluate the consistency or likelihood of continuance of any gains or losses reported on Schedule D. Compare at least two consecutive years of Schedule D to determine whether or not the income or losses are recurring. Confirm the likelihood of continuance by obtaining documentation that supports the borrower’s ownership of assets that will produce future gains or losses. Also, ensure that pass-through income from Schedule K-1 is not included.
Line 23 — Recurring Capital Gains/Losses: Add recurring gains to Total Income and deduct recurring losses from Total Income.
Form 4797 — Sales of Business Property
Except for farming, it is unlikely that gains/losses are recurring.
Line 24 — Recurring Capital Gains/Losses: Add recurring gains to Total Income and deduct recurring losses from Total Income.
Form 6252 — Installment Sale Income
Form 6252 is only required if there was a gain on the original sale that generated the contract.
If you see contract interest on Schedule B (not from a bank or credit union) but have no 6252, use the copy of the contract to determine full payments received if the contract will continue at least 3 years.
Take total scheduled annual payments and subtract the interest already in Schedule B to get the principal to add here.
Line 25 — Principal Payments: Only gains, losses and principal repayments are reported on this form (interest income is reported on Schedule B) and are carried forward to Schedule D and Form 1040. Schedule D gains or losses were negated in the first part of the analysis. Add principal payments to the borrower’s income only when they are determined to be stable and recurring. Obtain a copy of the note or contract to verify that payments will continue for at least three years.
Schedule E (Form 1040) — Rent and Royalty Income
PARTNERSHIPS AND S CORPORATIONS
OKAY, I confess! I find the way FNMA treats partners and S Corporation shareholders to be inconsistent with how it treats Corporation owners…and even sole proprietors. Oh, you too???
First, compared to sole proprietors. Using the ‘ordinary income/loss’ from Schedule K-1 for a Partner or S Corporation Shareholder would be just like using the bottom Line of Schedule C with no adjustments for depreciation or nonrecurring expenses. Lenders other than secondary market mortgage lenders use ‘partner withdrawals’ or ‘s corp shareholder distributions’ for low percentage owners, not share of taxable income.
I don’t get it.
Then, compared with corporation owners, if a partner or S Corporation shareholder owns more than 25% we’ll use the full 1065 or 1120S, cashflow it and make the adjustment to the personal return…EVEN IF IT IS POSITIVE! Not so with a Corporate Owner…he or she has to be 100% owner to get credit for cashflow left in the business.
Okay, enough of that. Suffice it to say if you have found it difficult to get a handle on how business owners are treated when they are not sole proprietorships, you are in good company.
The key, I believe, is to be sure first that you understand your investor’s guidelines. When a different approach will provide a better figure for qualifying income you need to know enough to spot it and have developed relationships with experienced underwriters who understand what you are trying to do.
And do they *really* mean you can only give the partner credit for ordinary income if they are a majority owner? If less than 50% but still pulling cashflow from the partnership, why in the world would we not count it? Yep, I still don’t get it.
LINE 37 – GUARANTEED PAYMENTS TO PARTNER
These are payments made to the partner regardless of profit/loss split. They can be somewhat comparable to wages paid to a shareholder who is also the owner of the corporation.
Our challenge is that sometimes the profit/loss split adequately portrays a fair split of cashflow, in which case guaranteed payments will be blank and the money withdrawn will all be up at Line J, Box d (withdrawals).
The FNMA 1084 does not seem to give you the option of using withdrawals (or distributions in an S Corp) instead but, for a partner, I’d sure consider adding the withdrawals and guaranteed payments together for a low % owner.
Remember, full disclosure and run this by the underwriter you are working with to get approval.
Income or losses reported on Schedule E was initially negated in the first part of the analysis. In this section of the worksheet, determine to what extent income or losses from real estate rental activities and royalties can be included in the analysis. Income or losses from partnerships and S corporations, which are also included on Schedule E, will be addressed below.
Line 26 — Gross Rents and Royalties Received: before analyzing the cash flow from rental properties, confirm that the borrower continues to own and rent all properties referenced in the schedule. Cross-reference the schedule of real estate owned as reported on the mortgage application with those listed in Schedule E and with mortgage obligations appearing on the credit report. Add ongoing gross rents received to Total Income. If the borrower has listed royalty income, it should be verified as ongoing and consistent before including it as usable income. Add royalties received to the borrower’s income when they are ongoing for three or more years.
Line 27 — Total Expenses before Depreciation: Subtract from gross rental income the total amount of expenses paid for property maintenance and upkeep. This includes all expenses reported on Schedule E except depreciation. The resulting calculation is the actual income from rental real estate activities.
Line 28 — Amortization/Casualty Loss/Nonrecurring Expenses: A borrower may occasionally claim amortization, casualty losses, or a one-time extraordinary expense, such as a new roof. When an amount is reported in Schedule E for these type expenses, add it back to Total Income.
Line 29 — Insurance, Mortgage, Interest, and Taxes: Add back the insurance, mortgage interest, and tax expenses reported on Schedule E when using the full PITI payment for all rental property to calculate the borrower’s qualifying ratios. Confirm that PITI payments include all elements — insurance, mortgage interest, and taxes. The initial step to negate Schedule E income or loss canceled out the effect of depreciation, depletion, and passive loss limitations on cash flow, therefore no adjustment is required for either of these items. When using other cash flow worksheets that do not calculate actual losses, add depreciation and depletion expenses to the borrower’s income. In addition, determine whether or not any properties were subject to passive loss limitations or used prior year unallowed losses. Prior year unallowed losses should be added back to cash flow and passive loss limitations should be subtracted. This step is not necessary, however, when using this worksheet.
Partnership Schedule K-1 (Form 1065)
Line 35 — Ordinary Income (Loss): Subtract ordinary losses from the borrower’s income. Add ordinary income from Schedule K-1 to borrower’s income only if:
• The business has positive sales and earnings trends;
• The business has adequate liquidity to support the withdrawal of earnings (Review the history of withdrawals shown in the analysis of partner’s capital account on the first page of the Schedule K-1 to determine a history or pattern of prior withdrawals. Review the partnership’s financial position and liquidity to determine the overall ability of the business to support the borrower’s withdrawal of earnings.); and,
• The borrower can document ownership and access to the income through a partnership resolution. (A majority ownership position, as disclosed on the first page of Schedule K-1 and indicating a majority ownership of capital, will provide sufficient evidence.)
Line 36 — Net Income (Loss): Add continuous and ongoing income to the borrower’s income if the three conditions listed above are met and the income is not reported elsewhere in the borrower’s tax returns. (Note that portfolio income, such as interest, dividends, and royalties, listed on Schedule K-1 is reported elsewhere on the 1040, therefore no adjustment is required.) Subtract ongoing losses from the borrower’s income.
Line 37 — Guaranteed Payments to Partner: Add guaranteed payments to partner to the borrower’s income when the borrower has at least a two-year history of having received them.
S Corporation Schedule K-1 (Form 1120S)
Line 38 — Ordinary Income (Loss): Subtract any ordinary losses shown on Schedule K-1 from the borrower’s income. Add ordinary income to the borrower’s income only if:
• The business has positive sales and earnings trends;
• The business has adequate liquidity to support the withdrawal of earnings (Review the history of distributions and the S corporation’s financial position and liquidity to determine the ability of the business to support the borrower’s withdrawal of earnings.); and,
• The borrower can document ownership and access to the income through a corporate resolution. (A majority ownership position, as disclosed on the first page of Schedule K-1 and indicating a majority ownership of capital, will provide sufficient evidence.)
Line 39 — Net Income (Loss): Add continuous and ongoing income to the borrower’s income if the three conditions listed above are met and the income is not reported elsewhere in the borrower’s tax returns. (Note that portfolio income, such as interest, dividends, and royalties, listed on Schedule K-1, is reported elsewhere on the 1040, therefore no adjustment is required.) Subtract ongoing losses from the borrower’s income.
Business Cash Flow: Partnerships, S Corporations, and Regular Corporations
BUSINESS CASHFLOW FROM PARTNERSHIPS,
S CORPORATIONS AND REGULAR (C) CORPORATIONS
I do not see it in the instructions, but generally we only go to the source returns when the borrower is a 25% owner or higher.
The following discussion for Partnerships applies to
S Corporations and regular Corporations for the most part.
The lender must analyze business tax returns to determine whether income from a Partnership, S Corporation, or Regular Corporation can be used to qualify the borrower. The business must show a consistent pattern of profitability for the income to be used. Losses identified by the lender’s analysis must be deducted from the borrower’s income since they represent a drain on cash flow
Partnership — Form 1065
LINE 45 – PRINCIPAL
This is a neat little shortcut for determining full outgo for business debt. And if every tax return was prepared correctly and business debt was always stable, it would work all the time.
If you are having a tough time qualifying the borrower, give this one a second look.
For example, if end of year principal is zero, assume the loans are paid off and you can add back the interest expense on page one of the return as nonrecurring.
If you can determine they have a balance on a seasonal commercial line of credit mixed in with the term debt principal, the shortcut will give you an incorrect result. (This is what the instructions mean when they mention that you do not have to subtract principal if the liabilities regularly rollover). One hint for this is when the amount of interest expense seems very low if that full amount were actually term debt principal.
If you can’t tell by looking, before you decline the loan ask the borrower about their business debt.
LINE 46 – MEALS
The instructions mention subtracting disallowed meals from the M-1, found on page four of the return. The meals are in the lower left hand corner of the M-1. What is not mentioned is nontaxed income, found in the upper right hand corner of the M-1. If they have significant recurring nontaxed income (like tax-exempt interest), add it somewhere and say what it is.
LINE 48 – TOTAL
This says to multiply the subtotal by the ownership share. However, the taxable income was split based on profit/loss share. If the profit/loss share is significantly higher, I recommend you use it, disclose and run it by the underwriter.
A partnership’s distributive earnings and losses are reported on Form 1065 for informational purposes only. The partnership does not pay taxes. Any income or loss is passed through to the partners, with their distributive shares being reported on Schedule K-1 (Form 1065). The borrower’s share of ordinary (net) income or loss from a partnership has already been addressed in the evaluation of Schedule K-1 (Form 1065). The analysis of Form 1065 will enable the lender to consider certain adjustments to the ordinary income or losses reported on Schedule K-1. When analyzing Form 1065, only the partner’s share of income or loss adjustments should be used to calculate income. The partner’s share is based on his or her percentage of capital ownership as reported on the Schedule K-1. The worksheet provides for this calculation.
Line 40 — Pass-through (Income) Loss from Other Partnerships: Income and losses from these sources should generally not be recognized. In this case, the partnership is a partner in another partnership. Before any of this income can be used to qualify the borrower, additional documentation is needed to support distributions are being made to the borrower’s partnership. In addition, the three conditions governing the use of K-1 income must be met relative to the partnership. In general, subtract ordinary income from other partnerships and add any ordinary losses from other partnerships.
Line 41 — Nonrecurring Other (Income) Loss: Subtract other income or add other losses that are not consistent and recurring.
Line 42 — Depreciation: Add depreciation to income.
Line 43 — Depletion: Add depletion to income.
Line 44 — Amortization/Casualty Loss: Add amortization or casualty loss to income.
Line 45 — Mortgage or Notes Payable in Less than 1 Year: These obligations may significantly affect the financial operations of the business. Subtract the amount of mortgage or note obligations payable in less than one year, as reported in Schedule L of Form 1065, end of year column. If there is evidence that these liabilities regularly rollover and/or there are sufficient liquid business assets to cover them, no deduction is necessary
Line 46 — Meals and Entertainment Exclusion: Subtract the meals and entertainment exclusion reported on Schedule M-1 of Form 1065 from the business income.
Line 47 — Subtotal: Add/Subtract all amounts on lines 40 to 46 to determine the amount to be recorded on this line.
Line 48 — Partnership Total: Multiply the subtotal (line 47) by the borrower’s ownership share of the partnership. The borrower’s share of ownership is based on his or her percentage ownership of capital (at end of year) as reported on the Schedule K-1.
S Corporation — Form 1120S
Please see my notes for partnerships. All the same applies except the following:
Instead of withdrawals on the front page of the K-1, if the shareholder has taken more out of the business in cashflow than in the form of wages (similar to a C corporation owner) it will show up on Schedule K-1, Line 20. This can be a HUGE amount and should be added. Where? FNMA does not give us a place to do it but it makes sense to go in the S Corporation Schedule K-1 section…perhaps Line 38?
Disclose, disclose, disclose.
Keep in mind that S Corporation shareholders often choose to take significant distributions INSTEAD of wages for purposes of minimizing payroll taxes. There is nothing wrong with this…in fact it is probably a smart move.
We *don’t* want to penalize borrowers for being smart when it comes to legitimate tax choices.
We *do* want to give them credit for all the cashflow they are legitimately deriving from their business activities. Ignoring the distributions on S Corporation Schedule K-1’s can kill the deal.
Form 1120S represents an S corporation’s distributive earnings and losses. This income or loss is reported for taxation purposes to the individual shareholders on Schedule K-1 (Form 1120S). The borrower’s share of ordinary (net) income or losses from the business has already been addressed in the evaluation of Schedule K-1 (Form 1120S). The analysis of Form 1120S will enable the lender to consider certain adjustments to the ordinary income or losses reported on Schedule K-1. When analyzing Form 1120S, only the borrower’s share of income or loss adjustments should be used to calculate income. The borrower’s share is based on his or her percentage of stock ownership as reported on the Schedule K-1. The worksheet provides for this calculation.
Line 49 — Nonrecurring Other (Income) Loss: Subtract other income or add other losses that are not consistent or recurring.
Line 50 — Depreciation: Add depreciation to income.
Line 51 — Depletion: Add depletion to income.
Line 52 — Amortization/Casualty Loss: Add amortization or casualty loss to income.
Line 53 — Mortgage or Notes Payable in Less than 1 Year: These obligations may significantly affect the financial operations of the business. Subtract the amount of mortgage or note obligations payable in less than one year, as reported in Schedule L of Form 1120S, end of year column. If there is evidence that these liabilities regularly rollover and/or there are sufficient liquid business assets to cover them, no deduction is necessary.
Line 54 — Meals and Entertainment Exclusion: Subtract the meals and entertainment exclusion reported on Schedule M-1 of Form 1120S from the business income.
Line 55 — Subtotal: Add/Subtract all amounts on lines 49 to 54 to determine the amount to be recorded on this line.
Line 56 — S Corporation Total: Multiply the subtotal (line 55) by the borrower’s percentage of stock ownership, as reported on the Schedule K-1.
Corporation — Form 1120
We apparently can use cashflow from partnerships and S Corporations if the borrower is a majority owner, but not corporations. Here we need 100% ownership.
This means if your borrower is a prudent, frugal sort who has not taken everything he/she could have from the corporation because they did not need it last year, we cannot assume they can take it now that they *do* need it.
My suggestion…if the borrower does not have enough wages to qualify but the corporation has significant excess cashflow, and your borrower is a high percentage owner, find a way to use the excess corporate cashflow to their advantage.
If you cannot add it to their cashflow the way we do for other business owners, use it in your narrative as a compensating factor.
LINE 65 – PRINCIPAL
See my notes about Partnerships for principal payment alternatives.
Line 57 — Taxable Income: The analysis of corporate income begins with Taxable Income as reported on the first page of Form 1120. (Note: Corporate earnings may be used to qualify a borrower only when the borrower can document 100% ownership of the business.)
Line 58 — Total Tax: Corporations are required to pay taxes on earnings (unlike partnerships and S corporations). To determine the available cash flow from the business, subtract the corporation’s tax liability from taxable income.
Line 59 — Nonrecurring (Gains) Losses: Determine the likelihood of continuance and stability of capital gains and net gains or losses reported on the first page of Form 1120. Subtract nonrecurring gains from the corporation’s income and add nonrecurring losses.
Line 60 — Nonrecurring Other (Income) Loss: Subtract nonrecurring other income and add other nonrecurring losses.
Line 61 — Depreciation: Add corporate depreciation to income.
Line 62 — Depletion: Add corporate depletion to income.
Line 63 — Amortization/Casualty Loss: Add corporate amortization or casualty loss to income.
Line 64 — Net Operating Loss and Special Deductions: These deductions do not represent actual current expenses or losses. Therefore, add net operating loss and special deductions to the corporation’s income.
Line 65 — Mortgage or Notes Payable in Less than 1 Year: These obligations may significantly affect the financial operations of the business. Subtract the amount of mortgage or note obligations payable in less than one year, as reported in Schedule L of Form 1120, end of year column. If there is evidence that these liabilities regularly rollover and/or there are sufficient liquid business assets to cover them, no deduction is necessary.
Line 66 — Meals and Entertainment Exclusion: Subtract the meals and entertainment exclusion reported on Schedule M-1 of Form 1120 from the business income.
Line 67 — Subtotal: Add/Subtract all amounts on lines 57 to 66 to determine the amount to be recorded on this line.
Line 68 — Subtotal Multiplied by Ownership Percentage: Multiply the subtotal (line 67) by the borrower’s percentage of stock ownership, as reported on the Schedule E (Form 1120) or other independent source. (This must be 100%.)
Line 69 — Less: Dividends paid to Borrower: Distribution (dividends) paid to stockholders are reported on Schedule M-2 of Form 1120. The borrower’s share of these distributions will be reported on Schedule B (Form 1040). These funds are also included in the corporation’s taxable income and are therefore being double counted. Therefore, subtract distributions paid by the corporation and reported on the borrower’s Schedule B (Form 1040).
Line 70 — Corporation Total: Line 68 less 69 equals total corporation income.
Year-to-date Income Analysis
Boy has this saved me more than once. When you have a borrower with a business that is growing, it can be very difficult to qualify them when you are using older returns.
In many cases if the year-to-date financial statement is consistent with the return of the previous year, you can average it in. (The 1084 instructions are worded this way.)
In other cases, the investor requires the financial statements be consistent with previous years’ (meaning two or more) returns, in which case averaging it in may not be allowed. (The 1084 Form is worded this way.)
Be sure you understand the guidelines. If you can average it in, that helps not only with a growing business but with one that had an unusually bad year (flood) that they have recovered from.
Year-to-date income from profit and loss statements may only be considered if the income and expenses are consistent with the previous year’s performance. Any salaries or draws received by the borrower, as well as any adjustments used when analyzing tax returns, such as nonrecurring income and expenses, depreciation, and depletion, may be added to the business cash flow. Note, however, that these adjustments are limited to the borrower’s proportionate share of ownership of the business.
My conclusion: Know enough about what the tax returns are really telling you so when the investor guidelines don’t lead to a reasonable estimate of recurring cashflow, you can spot it.
Once spotted, understand your investor’s guidelines well enough to know how to handle exceptions.
And get cozy with underwriters who are experienced enough to recognize a make-sense deal and help you document it so you can make the good loans!
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