Income

Details on specific types of self employed income

Someone who is self-employed is defined as a person who has a 25% or greater ownership position in a company or receives a 1099 document for their income. In some cases a borrower may own less than that, but because it is a major source of income and the ownership group is small, more documentation may be required. Additionally, borrowers who are employed by a family member are considered to be self-employed, no matter what the ownership percentage is. The potential ownership of a borrower must be addressed.

Here is documentation that is typically required for the following entities:

Sole Proprietorship:

  •       2 years of personal tax returns that include all schedules and signed by the borrowers
  •       Year-to-date Profit and Loss through current quarter
  •       The Profit and Loss Statement:
    •   Preparer/Reviewer must not be related and must be a qualified person such as an accountant or a bookkeeper
    •   If the business does not use a third-party preparer for tax documentation, a self-prepared year-to-date P&L and balance sheet are acceptable. However, an explanation must be provided to state the reason the borrower is unable to provide a third-party P&L and/or balance sheet.
    •   Must be signed by the preparer/reviewer and the borrower
  •   If the borrower is self-employed and the self-employment income is not used to qualify, the self-employed borrower must provide a copy of the first two pages and schedule 1 of the most recent individual federal tax return to determine whether there was a business loss that negatively impacts the borrower’s ability to repay. When that is the case, additional documentation about the self-employed borrower’s business income is needed to fully evaluate the impact of the business loss.

Partnerships (General, Limited), Limited Liability Companies, “S” Corporations and Corporations

Personal tax returns, including all schedules, for prior 2 years signed by each borrower

  •       Business tax returns (1065/1120), including all schedules, for the prior 2 years signed by each borrower
  •       K-1s from prior 2 years
  •       Year-to-date through current quarter’s P&L
  •       Balance Sheet
  •       The P&L and Balance Sheet:
    •   Must be prepared or reviewed by an unrelated and qualified individual (e.g. accountant / bookkeeper).
    •   If the business does not use a third-party preparer for tax documentation, a self-prepared year-to-date P&L and balance sheet are acceptable. However, an explanation must be provided to state the reason the borrower is unable to provide a third-party P&L and/or balance sheet.
    •   Must be signed by the preparer/reviewer and the borrower
  •     If the borrower is self-employed and the self-employment income is not used to qualify, the self-employed borrower must provide a copy of the first two pages and schedule 1 of the most recent individual federal tax return to determine whether there was a business loss that negatively impacts the borrower’s ability to repay. When that is the case, additional documentation about the self-employed borrower’s business income is needed to fully evaluate the impact of the business loss.

Retirement Income (pension, annuity, and IRA distributions)

  •      Retirement income may be used if properly documented.
  •      Employee Sponsored – document regular and continued receipt of income as verified by:
    •     Most recent bank statement evidencing automatic deposit, or
    •     Letters from the organizations providing the income or copies of retirement award letters, or copies of federal income tax returns signed by each borrower, pay stub, W-2 or 1099.
  • ·     IRA, 401(k), SEP, KEOGH retirement distributions – document by:
    •     Most recent two months or most recent quarter of retirement account statements, and
    •     Document income using most recent complete individual federal tax returns or IRS Form 1099-R.
    •     If there is a penalty for withdrawal, discount the income by the amount of the penalty to determine qualifying income.
    •     The funds must be 100% vested.
  •      Existing distribution of assets from an IRA, 401K or similar retirement asset account must be sufficient to sustain income continuance for a minimum of least 5 years. The continuance requirement may be reduced to three years if this income source contributes 25% or less of the qualifying income.  

Employment by Relatives or Transaction Participants:

  • If the borrower is employed by a relative, a closely held family business, the property seller, real estate agent, or any party to the real estate transaction, obtain the following documentation:
  •       Year-to-date paystub up through and including the most current pay period at the time of application and not earlier than 90 days prior to the Note date.
  •       W-2 forms for prior 2 years.
  •       Personal tax returns, including all schedules, for prior 2 years signed by each borrower.
  •       If the individual federal tax returns do not include W-2 earnings or income is lower than the current pay stubs, further investigation is needed to determine whether income is stable.
  •       If business is a corporation (filing their income and losses on the United States Corporation Income Tax Return, IRS Form 1120), obtain either of the following:
    •   A signed copy of the corporate tax return showing ownership percentage
    •   A signed letter from the corporation accountant stating the borrower has no ownership interest in the corporation

Dividend/Interest:

Interest and Dividend income may be used as long as documentation supports a 2-year history of receipt.

  •       Tax returns for the prior 2 years
  •       The income must be averaged over 24 months.
  •       Proof of asset(s) to support the continuation of interest and dividend income for minimum of 3 years.

Restricted Stock:

May be used for qualifying income when:

  •       Income has been received for 2 years as identified on paystubs, W2s and tax returns, and
  •       Documentation indicates continuance for a minimum of 5 years. The continuance requirement may be reduced to three years if this income source contributes 25% or less of the qualifying income.
  •      Issuance agreement or equivalent (part of the benefits package), and
  •      Schedule of distribution of units (shares), and
  •      Vesting schedule, and
  •      Evidence that stock is publicly traded
  •      Qualifying income is calculated using an average of the restricted stock income for the past two years.
  •      Future vesting must support qualifying income. The value of future vesting is based on the lower of 70% of current value or the two-year stock price average.
  •      To determine the restricted stock price use the lower of:

o    70% of the current stock price, or

o    the two year stock price average

Stock Options may not be used as qualifying income.

Rental Income

Another type of self-employment is Rental Income. The following documentation and advisement will help you understand how rental income is documented and calculated in general. Note that each investor may vary some, but overall this is a good general guide of what to expect:

  • The borrower must have 2 years of rental management experience*.  The stability of the rental income must be documented through 24 months of rental income history as verified by personal tax returns. This can include any rental property, not exclusive to the subject property.
  •          Rent may be received from investment properties or other units in an owner-occupied 2-4 unit property.
  •          Personal tax returns, including all schedules, for prior 2 years verifying 2 year history of rental management experience.
  •          Current lease for each rental property, including commercial properties listed in Part 1 of Schedule E of the 1040s. Rent rolls are unacceptable.
  •          When property has been owned less than 12 months and is not reflected on the borrower’s tax returns:
    •     leases may be used only if the borrower has a two-year history of property management experience as evidenced by the most recent two years’ complete individual federal tax returns.
    •     a vacancy/maintenance expense factor of 25% must be deducted from the rental income verified by the current signed lease agreement for determining qualifying income.
    •     For refinance transactions, three months of canceled checks or bank statements verifying receipt of rental income is required.
  •          Rental income for the subject property must be supported by operating income statement (216) or comparable rent schedule (1007).
  •          Rent loss insurance in an amount equal to a minimum of six months of the rental income is required if rental income is being used to qualify.
  •          Net rental income must be added to the borrower’s total monthly income. Net rental losses must be added to the borrower’s total monthly obligations.

*Note:  The two year rental management experience and rental income history requirement for rental income from the subject property is not required if all of the following apply:

  •          Purchase transaction
  •          Two-unit property
  •          Primary residence
  •          Credit Score greater than or equal to 740
  •          No gift funds

This should give you a good rundown on what self-employment income may be used, how it is used and what it will take to document it. As always, if you have questions please reach out. If you are not in Oregon, Washington or California, contact a local mortgage broker in your area for the greatest variety of programs, options and competitive rates.

Kristin M Eklund NMLS #1872091
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