Cash Distributions Do Not Support Ordinary Income

Fannie Mae classifies a borrower as self-employed if they have a 25 percent or greater ownership interest in a business. This definition applies regardless of how the business is structured, whether it is a sole proprietorship, partnership, limited liability company (LLC), S corporation, or corporation. The lender is required to verify this ownership percentage by reviewing the borrower’s federal income tax returns, specifically looking at forms like Schedule K-1 or IRS Form 1125-E. If the ownership share is less than 25 percent, the borrower is generally not considered self-employed for underwriting purposes, though specific documentation like Schedule K-1s might still be required.

Before approving a mortgage for a self-employed borrower, the lender must analyze several critical factors to ensure the income is safe and sustainable. The analysis must evaluate the stability of the borrower’s income, the specific location and nature of the business, and the current demand for the products or services provided. Furthermore, the lender must assess the financial strength of the business to ensure it can continue generating sufficient income for the borrower to meet financial obligations. This includes verifying that the business can support the withdrawal of income without negatively impacting its ongoing viability and operations.

Generally, Fannie Mae requires verification of a two-year history of the borrower’s prior earnings to demonstrate that the self-employment income is stable and likely to continue. However, a borrower with a history of less than two years—but at least one full year—may still qualify if their most recent signed federal income tax returns reflect a full year of self-employment income. In these cases, the lender must document that the borrower has a history of receiving income at the same or greater level in a similar field or occupation prior to their current self-employment.

To verify income, lenders typically must obtain complete, signed federal income tax returns (both individual and business) for the most recent two years, including all applicable schedules. Alternatively, lenders may use IRS-issued transcripts if the information is complete and legible. In certain scenarios, the lender may waive the requirement for business tax returns if the borrower has been self-employed in the same business for at least five years and their individual returns show an increase in self-employment income over the past two years. For loan casefiles underwritten through Desktop Underwriter (DU), only the most recent year of personal tax returns may be required.

A sole proprietorship is an unincorporated business individually owned by the borrower, where the owner holds unlimited personal liability. The income, expenses, and taxable profits are reported on the owner’s IRS Form 1040, Schedule C. To evaluate this income, the lender reviews the Schedule C to determine the net profit or loss. The lender must adjust the net profit by adding back recurring non-cash expenses, such as depreciation and depletion, while deducting non-recurring income that is not expected to continue. This adjusted figure helps the lender arrive at the borrower’s stable monthly cash flow available for mortgage qualification.

For borrowers owning 25 percent or more of a partnership or S corporation, the lender must analyze the business’s financial position using Schedule K-1 and relevant business tax returns,. The borrower’s proportionate share of income or loss is considered based on their ownership percentage,. Ordinary income reported on Schedule K-1 can be included in the borrower’s cash flow only if the lender confirms the business has adequate liquidity to support the withdrawal of those earnings,. If the business cannot demonstrate stable income and positive earning trends, the income cannot be used to qualify the borrower.

When qualifying a borrower using ordinary income reported on Schedule K-1, the lender must confirm the business has adequate liquidity to support the actual withdrawal of earnings,. This step is not required if the Schedule K-1 reflects a documented history of stable cash distributions consistent with the qualifying income. If confirmation is necessary, the lender may calculate a liquidity ratio, such as the Quick Ratio or Current Ratio, using the business’s tax returns,. A result of one or greater generally confirms the business can support the withdrawal of earnings without harming operations.

Yes, business assets may be used for the down payment, closing costs, and financial reserves, provided the borrower is an owner of the account,. However, the lender must perform a business cash flow analysis to ensure that withdrawing these funds will not negatively impact the business’s ability to operate. To make this determination, the lender may need to review additional documentation, such as several months of recent business asset statements or a current balance sheet, to observe cash flow trends. The analysis must confirm the withdrawal fits within the business’s financial capacity.

Lenders must evaluate year-to-year trends in business income. If the business shows a steady or significant decline in earnings, the lender must investigate the cause to determine if the trend will reverse,. Generally, if the income has declined by more than 20 percent over the analysis period, the income is not considered stable and cannot be used unless the lender documents that the business has stabilized,. In cases where the decline was caused by extenuating circumstances, the income may be considered stable after a 20 percent reduction if the borrower demonstrates stability for at least 12 months.

The Fannie Mae Income Calculator is an optional tool available to lenders for calculating monthly qualifying income for self-employed borrowers. It analyzes self-employment income on a business-by-business basis and generates a Findings Report summarizing the qualifying income, trending analysis, and business liquidity. If the lender uses the income amount calculated by this tool, they may receive relief from enforcement of representations and warranties regarding the accuracy of the income calculation,. This tool can be utilized for loans underwritten manually as well as for loan casefiles submitted to Desktop Underwriter (DU).