Ask the Underwriter is a regular column for HousingWire's new LendingLife newsletter, addressing real questions asked to, and answered by, professional mortgage underwriter, Dani Hernandez.
I have a borrower who is looking to purchase a new home. They are employed by a large corporation and qualify for the loan using only their W-2 income. However, the borrower has a Schedule E loss on their tax returns from Self-Employment through an S-Corporation. If the borrower qualifies using only their W-2 income, do I need to include the self-employment loss in their debt-to-income ratio?
You do not need to include any income or loss from self-employment if the borrower qualifies for the mortgage loan using only W-2 income. Fannie Mae allows you to omit any income or loss from self employment in this situation.
When determining the appropriate qualifying income for a self-employed borrower, it is important to note that business income (specifically from a partnership or S corporation) reported on an individual IRS Form 1040 may not necessarily represent income that has actually been distributed to the borrower. The fundamental exercise, when conducting a self-employment income cash flow analysis, is to determine the amount of income that can be relied on by the borrower in qualifying for their personal mortgage obligation. When underwriting these borrowers, it is important to review business income distributions that have been made or could be made to these borrowers while maintaining the viability of the underlying business. This analysis includes assessing the stability of business income and the ability of the business to continue to generate sufficient income to enable these borrowers to meet their financial obligations.
Analysis of Borrower’s Personal Income
The lender must prepare a written evaluation of its analysis of a self-employed borrower’s personal income, including the business income or loss, reported on the borrower’s individual income tax returns. The purpose of this written analysis is to determine the amount of stable and continuous income that will be available to the borrower. This is not required when a borrower is qualified using only income that is not derived from self-employment and self-employment is a secondary and separate source of income (or loss). Examples of income not derived from self-employment include salary and retirement income.
The lender may use Form 1084 or any other type of cash flow analysis that applies the same principles as Fannie Mae’s form.
A copy of the written analysis must be included as part of any loan application package that the lender submits to Fannie Mae for a mortgage that is selected for a post-purchase quality control review.
Because many lenders have questioned exactly how to interpret this guideline, Fannie Mae has gone further and provided guidance on how this guideline should be applied:
Q4. Fannie Mae does not require lenders to prepare a written evaluation of self-employment income when the borrower is qualified using only income that is not derived from self-employment. Does that allow lenders to disregard business losses that borrowers may be reporting for tax filing purposes outside of their employment?
Fannie Mae does not require lenders to review or document income from secondary sources when that income is not needed to qualify. Business-related debt for which the borrower or co-borrower is personally obligated would likely be on their credit report and therefore already included in the debt-to-income ratio. As a practical consideration, borrowers with a primary source of income that is not derived from self employment and is sufficient to cover the obligation have more flexibility and could discontinue a secondary self-employment activity should it prove unprofitable. Consequently, it is our view that if the income not derived from self-employment is sufficient to qualify the borrower, no further inquiry regarding any secondary business losses is required.
As long as your borrower qualifies for the loan with W-2 income only, Fannie Mae explicitly states that you do not have to include and income or loss from self-employment and you can forget about documenting it as well!
Keep in mind that some investors will impose their own overlays that supercede Fannie Mae’s guidelines. So it is important to ask your investors what their policy is so that you do not end up with an unsaleable loan.