Qualifying for a mortgage can be a challenge for many people, but self-employed borrowers will usually experience more challenges than someone with W-2s and VOMs. Lenders must rely upon tax returns and all supporting schedules to verify the income of the self-employed borrower and that is where problems can occur. The self-employed person is not more of a financial risk; there is just more paperwork involved documenting income. In other words, tax returns are put under the lender’s microscope. In my experience, when someone wants to qualify with tax returns, this can be a definite DEAL KILLER. Taxable income very often is lower than actual cash flow due to deductions allowed on tax returns. So what works for the IRS doesn’t necessarily work for the lender, and qualifying ratios may be way out of line.

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There are many classes and books that explain in detail how tax returns are analyzed, so it is extremely important to your success as a loan officer to take advantage of any information or classes available on evaluating tax returns. Even though we are not going to evaluate tax returns line by line, remember the basic formula: Always look at the Adjusted Gross Income on the bottom line of the 1040 form, page 1. This is the income that you will use as a base line to qualify. Adjusted Gross Income is the gross income minus any allowable deductions. You can add back any non-cash expenditures in order to determine income that will be consistent and stable. You must also adjust the income for any expenses or losses not recognized by the IRS that may be included in your final income figure.

Before we go any further, I think it is important to define exactly who is considered self-employed. Borrowers are considered self-employed if:

• they own at least 25% of a business, corporation, or partnership, or
• if at least 25% of income comes from commissions, guarantees or bonuses.

The following list of documents is required by most lenders for a self-employed borrower. Individual lenders may need additional documentation:

1. Corporation

• If the borrower owns at least 25% of a corporation, copies of 2 full years of the most recent corporate or partnership tax returns.
• Personal 1040s as well as corresponding W-2s for the past 2 years if the borrower receives a regular paycheck from the corporation with taxes and other deductions taken out.
• Year-to-date Profit and Loss statement for the corporation.
• Financial statements for the corporation for the past 2 years.

2. S Corporation

• Personal tax returns with all schedules for the past 2 years.
• Year-to-date Profit and Loss statement.

3. Sole Proprietor

• Personal tax returns will all schedules for the past 2 years.
• Copies of any 1099s for the last 2 years.
• Year-to-date Profit and Loss statement.
• Federal Tax I.D. number

4. Partnership

• Federal Partnership Returns for the past 2 years.
• Partnership agreement.
• Personal tax returns for the past 2 years.
• Year-to-date Profit and Loss statement.
• K-1 Schedules (for Limited Partnership only) for the past 2 years.

As you see from the above documentation, lenders will always request 2 years of tax returns. This allows the lender to average income over the past 2 years and then to compare that average with a year-to-date profit and loss statement. Lenders will want to see the business is prospering and the income trend is steady or on the rise. If income is declining and there aren’t a lot of compensating factors, such as excellent credit, large down payment or good savings, this could be a reason to reject the loan. For all self-employed borrowers, lenders will also want to see the following:

• Assets, which include stocks, bonds, bank accounts, real estate, vested interest in retirement funds, personal property, rental income and depreciation.
• Liabilities including credit card debt, loans for the business and loans personally signed for, stock pledges child support, alimony, other mortgages or negative cash flow from income property. Remember that lenders will use the same qualifying ratios and guidelines for both salaried and self-employed borrowers. This is where the problem begins. Self-employed borrowers funnel much of their profits back into the business, which enables them to reduce their taxable income. This is great when it comes to dealing with Uncle Sam but it plays havoc when trying to qualify for a mortgage!

EXAMPLE: Ms. Braken showed a 2-year average income of $95,000 but she wrote off $61,000 in taxable deductions on her tax returns. She has only $34,000 in adjusted gross income to use for qualifying purposes. If we take this one step further, an income of $95,000 would mean Ms. Braken could afford a monthly mortgage payment of $2,216.67. An income of $34,000 would mean she could afford a mortgage payment of only $793.33. The difference in mortgage payments is significant and shows why so many self-employed people have such a hard time qualifying for a mortgage.

Lenders will also look at the history of the borrower’s business and consider the following factors:

• Does the business continue to show a profit?
• Is this business in an area or location that will help its profitability?
• Does the borrower show she has enough experience and training to be successful in this business?
• Is this business one that will be in demand for some time to come?
• If the borrower has not been self-employed for a full 2 years, has he or she had at least 2 years in the same occupation?

Providing mortgages for the self-employed is a challenge. It is imperative that to be successful in the mortgage industry, you must know the basic information needed to analyze tax returns. It would be helpful to obtain training on understanding tax returns. There are usually seminars offered on this subject and lenders or underwriters can also direct you to information and guidelines for the self-employed.

©2004, Jeannine Doyle, D&S Publications. Jeannine Doyle has turned her 25+ years experience into manuals and CDs that explain the complexities of lending in plain language for loan officers, real estate agents, students, and those considering a career in lending. This article is an excerpt from Managing the Mortgage Maze. For more about this comprehensive guide, visit www.MortgageMazes.com. Jeannine is a member of the National Advisory Council for GoGetLoan.com. Visit her page here.