As the mortgage industry continues to experience a dramatic increase in loan modifications, understanding how to analyze the income of a self-employed borrower has become a valuable skill for servicers to attain. Mortgage professionals know that analyzing income to establish a borrower's ability to repay a home loan is the cornerstone of mortgage risk analysis.
And as servicers try to determine the appropriate workout path for self-employed borrowers, the ability to determine stable and continuing income is the foundation for correctly calculating their qualifying income.
In order to create successful loan modification strategies, servicers must know not only how to determine a self-employed borrower's qualifying income, but also how he or she specifically generates this income. Despite common perceptions, qualifying income is not the same as taxable income reported on a tax return, but the return is the source for determining qualifying income.
Additionally, servicers are not expected to understand the minutia of accounting to accurately review the tax return of a self-employed borrower. Rather, they are required only to understand where the income is documented and why the mortgage industry uses tax returns to document it.
Industry protocol dictates that self-employed borrowers must have the capacity (i.e., ability in the form of income documents), willingness (i.e., credit history) and security/collateral (i.e., property) to repay a home loan.
This article focuses specifically on borrower ability. When analyzing a self-employed borrower's income, servicers must realize that no two self-employed borrowers or their tax returns are ever the same. Therefore, each case must be reviewed independently and according to the file's own merits.
Lending to self-employed borrowers is risky because their income streams tend to vary based upon the success of their business, making their income difficult to document. Moreover, when faced with financial complications, self-employed borrowers are often forced to prioritize between their business and personal financial obligations. As a result, these types of borrowers have higher delinquency and foreclosure rates than those of wage earners employed by others.
The tax return of a self-employed borrower provides both an objective and consistent reporting of his or her income stream. For the manually underwritten loan application process, self-employed borrowers must provide two years of these returns.
Alternatively, Fannie Mae's and Freddie Mac's automated underwriting processes do not always require this level of documentation. Given increased risk in the current economic climate, however, many lenders are requiring more levels of documentation than ever before.
By requesting two years of personal and business tax returns, servicers are able to establish the stability of a self-employed borrower's income stream. In doing so, they are looking for income that is both regular and recurring. Regular income is predictable and consistent.
Servicers can determine recurring income by examining the history and trends of a self-employed borrower's income. This, in turn, helps to predict the future of the income stream.
It is again important to note that taxable income is not the same as qualifying income. The federal government allows certain reductions to income so that a borrower's tax burden can be reduced. Every taxpayer's goal is to document the least amount of income possible on his or her tax return.
The mortgage industry, on the other hand, depends on these tax returns to determine borrowers' capacity. A servicer's objective in analyzing self-employed borrowers' tax returns, therefore, is to determine the most income available.
Objectives of income analysis
The main objective in analyzing a self-employed borrower's tax return is to determine his or her ability to repay a loan. In order to do this, mortgage professionals must first determine the viability of the business. The following questions are crucial in determining the viability of a self-employed borrower's business:
- How long has the borrower been in business?
- How long has the borrower been self-employed?
- What is the likelihood of the business continuing?
Once a self-employed borrower has met a mortgage professional's requirements for viability, he or she can be assessed for ability to repay the loan. The best way to determine borrower ability is to use the Fannie Mae Cash Flow Analysis Worksheet, also known as Form 1084.
Both Fannie Mae and Freddie Mac, as well as most other investors, accept qualifying income that is derived from Form 1084. The cashflow analysis inherent in this form analyzes both the personal return and the business entities by making adjustments to income and evaluating deductions accordingly.
While there are other methods for analyzing self-employed income, the cashflow analysis method is currently the industry standard, because it helps derive the most income for the borrower.
Form 1084 breaks down the analysis of a self-employed borrower's tax return by examining cashflow from the appropriate schedules and forms. It is important to note that very few borrowers will have entries on all lines of the 1084. Additionally, many line items have both a "+" and "-", allowing for addition of allowable income and expenses, as well as subtraction of nonrecurring income and expenses.
Form 1084 is organized to follow the schedules and forms of personal and business tax returns. As mentioned earlier, the form analyzes specific income and deductions while looking for income that is both regular and recurring. The form also requests specific information and then asks the mortgage professional reviewing it to add or subtract the respective income or loss.
At the bottom of the worksheet is the analysis of K-1s for both "partnership" and "S corporation" entities. Page two of the 1084 form analyzes the "partnership," "S corporation" and "corporation" entities. The calculations are totaled, and the form concludes with an analysis of the year-to-date profit and loss statement.
What to look for
Regardless of the entity type, servicers need to verify that the business has consistent revenue and profitability, stable sales and earnings trends, as well as the continued ability to support income withdrawals. In addition, there are unique aspects of each entity that should be considered.
A sole proprietorship is one of the riskiest types of self-employment, because the borrower owns and controls 100% of the business. Therefore, the success or failure of the business rests on the shoulders of a single person.
Schedule C of the 1040 is where a sole proprietor reports the profit or loss of the business entity. This schedule is formatted with the sole proprietor's information at the top of the form; it should match both the 1040 and loan application.
Gross income is represented by gross receipts (i.e., revenue) less cost of goods sold (and returned). Not all sole proprietors will indicate cost of goods sold on their tax returns. If the company is a service company, for example, there may be no direct costs.
Part II of Schedule C represents the expense section of the 1040 form. Expenses listed are those expenses required to operate the business. While these expenses are the cost of making a self-employed borrower successful, there are certain items that have the potential to be added back into qualifying income.
These, in turn, are items of particular interest when analyzing how the total income of a self-employed borrower may be adjusted. Tax areas addressed in this section include depletion, depreciation, meals and entertainment exclusion, business use of home and other expenses.
A partnership has two or more partners who invest in a business. This type of business does not pay taxes on its income, but rather, the taxable income or loss is passed through to the borrower's personal return and taxed on the individual's personal tax rate.
A partnership reports income/losses on Form 1065. The K-1-1065 schedule and Part II, Schedule E of the 1040 indicate where a percentage of a partner's income/loss can be passed through to his or her personal tax return, the 1040. To document the income of a borrower in a partnership, servicers should request two years of 1040 tax returns (including K-1s).
The K-1 1065 schedule is a source document for income or loss reported on Schedule E. Servicers should think of a K-1 as they would a W-2. The tax areas represented by a Partnership Schedule K-1 include percentage of ownership, ordinary income and loss, net income and guaranteed payments to partner.
In analyzing this form, servicers must remember the importance of being both conservative and methodical in their thinking. Oftentimes, a self-employed borrower may have a guaranteed payment as a partner, but this does not always mean that the payment should be counted toward qualifying income.
Income needs to be both regular and recurring, and it must correspond to what is on the loan application itself. If the partner is receiving a guaranteed payment but the partnership is barely breaking even or shows signs of trouble, it may make more sense not to count this toward qualifying income.
An S corporation is a state-chartered business that has enhanced borrowing capacity and income-generation abilities due to the pooling of stockholder resources. As in the previous two business structures, the S corporation does not pay taxes on its income/loss, but rather the taxable income or loss is passed through to the borrower's personal return and taxed on the individual's personal tax rate.
An S corporation reports income/losses on Form 1120S, the U.S. tax return for an S corporation. The K-1-1120S schedule and Part II of the 1040 Schedule E indicate where a stockholder's (i.e., borrower's) income/loss can be passed through to his or her personal tax return.
To document the income of a borrower in an S Corporation, servicers should again request two years of 1040 tax returns (including K-1s).
Form 1120S is a shorter version of the Partnership Schedule K-1 (i.e., Form 1065). This document is completed for S corporations, and the tax areas represented include percentage of ownership, ordinary income and losses, and net income. The review of the S corporation is similar to that of a partnership, and the same considerations apply.
A corporation is also a state-chartered business entity, but with an unlimited number of shareholders and greater ability to raise capital. The corporation – not its stakeholders – is liable for debts. The corporation, however, has one major difference setting it apart from the other self-employed borrower types: It pays taxes twice.
A corporation reports and pays taxes on its income/losses on Form 1120, which is the U.S. corporate tax return. In Form 1040, income generated from the corporation is passed on to stockholders as wages or dividends and reported on their 1040s, thereby taxing the corporation's income twice. Wages from the corporation are typically reflected in W-2 wages and dividend distributions shown on 1040 Schedule B.
To document the income of a borrower with interest in a corporation, servicers should request two years of 1040 tax returns. Business income reported on Form 1120 can be considered, but only if the borrower is the 100% owner of the corporation. Otherwise, income is limited to that documented through the 1040.
Limited liability company
A limited liability company (LLC) is like a chameleon in that it can mimic any of the four previously discussed business structures. The LLC is liable for the debts and losses of the company, but the members are not personally liable (similar to a corporation). The LLC can be taxed as a pass-through entity (e.g., partnership), S corporation or as a regular corporation.
How an LLC reports income to the IRS is dependent upon how it is structured. The LLC reports income/loss on the following:
- Form 1040, Schedule C, E or F, if the LLC has only one member and that member is an individual. If the LLC has only one individual member, servicers should request two years of 1040 tax returns.
- Form 1120 or 1120S, if the only member of the LLC is a corporation. If the LLC has only one corporate member, servicers should request two years of 1040s, including K-1s and 1120S returns.
- Form 1065, if the LLC is composed of multiple members. If the LLC is composed of multiple members, servicers should request two years of 1040s, including K-1s and 1065 returns.
With appropriate training on the front end of the tax return assessment process, servicers can realize many positive gains on the back end. The most significant of these include determining the best way to modify a self-employed borrower's mortgage, as well as anticipating the likelihood that he or she will stay current with a given modification.
Carole A. McKinney, a training specialist with Radian Guaranty Inc., has over 20 years of mortgage banking experience managing quality control and operational departments. She can be reached at firstname.lastname@example.org.