We just obtained mortgage commitments for two self-employed borrowers. The thing is, they never would have received one if not for the way we structured the deal. They had weak earnings in 2014, but 2015 was better. They had confidently gone to contract, with their pre-approval in hand, not realizing that they would not qualify for their mortgage financing as is. They needed two years of tax returns, and willingly supplied them, yet it didn’t help them because Wells Fargo declined them. They still wanted to buy the home. The seller was breathing down their necks. What did we do? In short, we focused on 2015 and 2016 returns (2016 was not prepared yet) and came up with a way to make the income numbers work, and then we told them, “File your 2016 return ASAP!”
The two important factors considered when underwriting a self-employed borrower are: Is the business profitable? And are earnings stable or increasing from the prior year(s)?
When it comes to calculating the income needed to qualify, the income you think you have is not always what you get credit for. Below you’ll find the key tax forms that are looked at by mortgage underwriters when reviewing income.
Main federal tax forms for underwriting the self- employed:
Sched C – Tip: depreciation can be added back
Sched E – Partnerships (federal form 1065) and S corps (federal form 1120S)
To get additional income from the 1065:
Add together:
The Depreciation and Depletion (lines 16C, 17)
Amortization/Casualty Loss (line 20 under “other deductions,” but you will need statement attached)
Then subtract:
Meals and Entertainment and Mortgage/Notes payable in less than one year.
Meals and Entertainment (line 20 under “other deductions,” but will need statement attached. Mortgage Notes Payable in less than one year (Schedule L, line 16—use end-of-tax-year column).
Multiply the total amount by the percentage of ownership listed on the K-1s.
To get additional income from the 1120S:
Add together the Depreciation and Depletion (lines 14 and 15).
Amortization/casualty loss (line 19 under “other deductions,” but you will need statement attached).
Then subtract:
Meals and Entertainment and Mortgage/Notes Payable in less than one year.
Meals and Entertainment (line 19 under “other deductions,” but will need statement attached. Mortgage Notes Payable in less than one year (Schedule L, line 16— use end-of-tax-year column).
Multiply the total amount by the percentage of ownership listed on the K-1s.
C Corporations (1120):
Typically, the only income that can be used is the borrower’s W2 income from the company.
Profits of a corporation are not moved over to the client’s individual tax returns, therefore they cannot be used to qualify.
If the client is 100% owner of the corporation, depreciation and depletion can be added back, but we must deduct mortgage/notes payable in less than a year
Net Operating Losses:
What is a NOL?
Small businesses with deductions exceeding their income can use a NOL tax provision to get a refund of taxes paid over five years.
If a client has a NOL, it will show up on line 21 (other income) of the client’s 1040. What does this mean to us?
- a) The NOL can be excluded in certain circumstances, but more documentation will be needed.
- b) If the business has negative income and the NOL is increasing or reoccurring, both the NOL and the business loss must be included as self-employment loss (not treated as a debt).
Section 179 expenses:
What is a 179 expense?
It allows a business to deduct the full purchase price of equipment and/or software purchased during the tax year. This means that you can deduct the full purchase price from your gross income. It’s an incentive created by the IRS to encourage businesses to buy equipment and invest in the success of their businesses.
Section 179 expenses will be shown on Schedule E of the client’s 1040.
Since 179 expenses are deducted from income; we cannot add them back to qualify unless we can document that it’s a one-time expense.
We cannot add back 179 when the expenses are recurring expenses (must buy new equipment every year).
To add back the section 179 deduction to income we will need to see: The Form 4562 to show the description of the equipment purchased. Typically, smaller purchases (camera equipment, software updates, etc.) will not be added back. Large equipment that will last (truck, bulldozers, etc.) can be considered one-time equipment purchases added back to income.
Other deep, dark mortgage secrets:
Amended Tax Returns (1040X): Amended tax returns (1040x) are generally filed when a client filled out their original 1040s in error. A 1040X is only allowed if the income stated is lower than the original income and we must use the more conservative income amount. The borrower must provide the complete, original return along with the amended return. A 1040X is not acceptable if the income is higher than the original filed return.
If a borrower provides a 1040X with lower income, the amended return and lower income will be used. If the client provides a 1040X with higher income, then the original lower income from the initial filed 1040 will be used. After 8/15, the tax returns for the previous year must be filed
Proof that Current Business Exists:
All loans require proof of self-employment dated within 30 days of closing.
The following will be verified: Business is active, borrower is the owner, independent third-party verification of business address and phone number.
By Carl Guzman
Carl Guzman, NMLS# 65291, CPA, is the founder and president of Greenback Capital Mortgage Corp. He is a residential financing expert and a deal maker with over 25 years experience. Carl and his team will help you get the best mortgage financing for your situation and his advice will save you thousands! www.greenbackcapital.com [email protected]
