Mortgage Loan Originator Income Tax Analysis

1. Income Tax
Analysis
Mortgage Professionals

2. Disclaimer
The information presented in these training materials is
for general information only, and is based on
guidelines and practices generally accepted within
the mortgage finance industry and is not intended to
be all-inclusive.
You need to structure your loans based upon your
company guidelines and investor overlays.

3. Introduction
Underwriting loans for the self-employed borrower is a
complex and challenging task. Each case is unique,
requiring a special set of skills to analyze this type of
borrower. The income of self-employed borrowers
must be analyzed differently due to the nature of self-employment.
Determining whether borrowers can and will repay a
loan is difficult because obtaining an estimate of their
earnings from tax returns can be confusing.

4. Introduction
The primary problem is that for self-employed
borrowers, their accountants are experts at reducing
tax liabilities by minimizing current net income, while
we as mortgage professionals rely on that same net
income as a gauge of their earnings.
The tax return reveals the borrower’s taxable income.
But what you are really looking for is the borrower’s
cash flow.
Cash flow is what is used to pay back the loan.

5. General Income Documentation
Requirements
• Length of Employment
o A two-year history of receipt of stable income is generally required
• Stable and Predictable Income
o Guidelines emphasize the continuity of a borrower’s stable income.
o Stable and predictable income is stressed more than stability of
employment.
o Less predictable income sources require more supporting documentation.
• Adequacy of Income
o We must document and evaluate the borrower’s ability to repay the
mortgage.
• Continuity of Income
o We must document the likelihood of continued receipt of income for at
least 3 years.

6. General Income Documentation
Requirements
• We must assess the level of income in the
o past (historical patterns),
o present (exists today and is stable)
o and future (predictable and likely to continue).
• Declining income sources should be closely
reviewed to determine if the income may be used
for qualifying purposes.
o a consistent decline might not be considered stable.
o In instances where there is sufficient information to support the use of the
declining income, only the most recent year lower income must be used.

7. Why Use Tax Returns?
• Self-employed borrowers are not typical.
• There is no “independent third-party” to verify
employment and income.
• The most credible sources to verify income are the
tax returns that have been submitted to the IRS.
• Borrowers should sign the signature page of all tax
returns to indicate the forms provided are a true
and correct copy of those documents filed with the
IRS.

8. Personal Tax Returns
• Personal tax returns reveal the borrower’s taxable income. But
what you are really looking for is the borrower’s cash flow.
• A cash flow analysis is required to examine a self-employed
borrower’s personal income, including the business income or loss
reported on the borrower’s personal tax returns.
• To analyze cash flow, tax statements are a starting point. Income
is increased by the noncash expenses and decreased by any real
losses or expenses that were not included in the taxable income.
• There are three key income/expense components that appear
throughout the cash-flow analysis:
o Noncash expenses (ex. depreciation)
o Recurring vs. nonrecurring income or loss (ex. business earnings vs. one-times sale of an asset)
o Losses and expenses limited by the IRS (ex. meals and entertainment)

9. Business Tax Returns
• An analysis of business tax returns is used to
evaluate the consistency of profitability and the
potential for long-term earnings.
• This analysis of profitability can impact the
borrower’s cash flow if
o The business has positive sales and earnings trends;
o The business had adequate liquidity to support a withdrawal; and
o The borrower can document ownership and access to the income.
• Certain losses may need to be deducted.
• Note that guidelines can vary significantly on the
use of income from business sources. Consult your
company and/or investor guidelines.

10. Automated Underwriting
Both Fannie Mae and Freddie Mac provide guidance on
how to assess the loan applications of “self-employed
borrowers” using their respective automated underwriting
systems.
There are some basic rules for underwriting self-employed
borrowers.
You should pay close attention to the documentation
requirements listed on the underwriting findings report.
Depending on the overall borrower profile, automated
underwriting system results may differ from loan to loan.
For example, the underwriting findings report may only
condition the loan for 1 year’s personal federal tax return.

11. Income that Requires Tax Returns
Self Employed Income
An individual receiving income from any of the following
sources must be qualified as self-employed:
• Borrower has an ownership interest of 25% or more in a
business. The business may be a sole proprietorship, a
general partnership, limited partnership, corporation, or S-corporation;
• Borrowers whose combined business interests in the same
corporation are 25% or more of the total ownership.

12. Income that Requires Tax Returns
Self Employed Income
• A 2-year self-employment history, which includes verifying the
borrower has ownership in the business, is generally required to
ensure that the income is stable.
• Less than 2 years may be considered provided the borrower
has a recent 2 year history of successful employment in the
same occupation (or a related field) and they have been self-employed
for at least 1 full tax year.
• Depending on Automated Underwriting Findings, the
requirement to obtain and review business tax returns may be
waived.
• Generally, a 24 month average is used to determine stable
gross monthly self-employed income. If wide fluctuations
occur in the income, a 36 month average may be requested.

13. Income that Requires Tax Returns
Partnership Income
• A partnership is a legal form of business, which has
two or more partners. General partners have
unlimited personal liability for the debts and losses
while limited partners are only liable for the amount
of their investment in the partnership. The partners
control the partnership and the amount of control
each partner has is addressed in the partnership
agreement. In addition to an individual Form 1040,
the partnership will file a Schedule K-1 with Form
1065.

14. Income that Requires Tax Returns
Partnership Income
• When an applicant is a limited partner with less than 25%
interest, as in a law or accounting firm, and partnership
income is needed to qualify in addition to wages received,
the applicant must provide 2 years personal tax returns with
the Schedule K-1 for the partnership. The K-Is must be reviewed
to determine whether there are capital contributions being
made. If there are capital contributions, the partnership
agreement must be obtained to determine the amount of
further required contributions. The earnings will be decreased
by the amount of capital contributions and the income
averaged over two years.

15. Income that Requires Tax Returns
Partnership Income
Guaranteed payments to partners may be used as income
based on providing the following documentation:
1. Two years of signed personal tax returns reflecting the receipt
of guaranteed payments, which will be reported income on
Schedule E, along with K-1s.
2. Two years signed 1065 Partnership Returns reflecting:
1. The income is stable, consistent, and likely to continue for
at least 3 years,
2. The business has positive sales and earnings trends,
3. The business has adequate liquidity to support the
withdrawal of earnings.
3. Income to be averaged over 2 years.

16. Income that Requires Tax Returns
Commissioned Earnings
• Commission income is a fee or percentage paid to the
employee for performing a service or is based on the dollar
amount of the goods and/or the number of units a person
sells. Some borrowers are paid a salary plus commission while
others receive only commission pay.
• If the borrower does not have a history of receiving
commission income for at least 2-years, the income may only
be considered if there are solid compensating factors and a
future earnings trend can be demonstrated.

17. Income that Requires Tax Returns
Commissioned Earnings
• Borrowers who receive 25% or more of total income from
commission must be qualified using self-employed guidelines.
• Two years of personal tax returns and a 24 month average of
income/loss will be used to qualify.
• Income may be subject to fluctuations from year-to-year. If
there are large fluctuations, the appropriate adjustments
made to average income used to qualify.
• AUS findings may provide relief for documentation
requirements.

18. Income that Requires Tax Returns
Capital Gains
• When income from capital gains will be used to qualify the
borrower, 2 years tax returns will be required to determine if it is
recurring and can be included or should be excluded from
the qualifying income.
• If a capital gain or loss appears to be a one-time occurrence,
it should not be considered when calculating income
available.

19. Income that Requires Tax Returns
Contract Employee
• A Borrower who works on a contractual basis rather than as an
employee is treated as a self-employed borrower. Because
the individual may be released from employment at any time,
or as specified in their contract, employment history is crucial
when establishing income stability and the likelihood that it will
continue.
• All independent contractors will be treated as a self-employed
borrower. Two years signed and dated personal tax returns.
• AUS findings may provide relief for documentation
requirements.

20. Income that Requires Tax Returns
Dividends and Interest
• Interest income from bank accounts, bonds, savings bonds,
money market funds and stock dividends is acceptable if
verified.
• Such income should be adjusted appropriately if any or all the
assets are liquidated.
• The most recent preceding 2 years signed and dated tax
returns, including applicable schedules, are required to verify
the amount and stability of the income as well as develop a
two-year average of the income.
• A 1099 form may be used in lieu of the tax returns to verify
interest and dividend income.
• File must also contain documentation to verify funds remain
on deposit.

21. Income that Requires Tax Returns
Rental Income
• Rental income is substantiated with one or two years tax
returns as required by AUS.
• There are specific documentation requirements for
o “Rental Income from Property other than Subject Property”
and
o “Rental Income-Subject Property”.

22. Income that Requires Tax Returns
Employed by Family Owned Business or Transaction-Interested Party
Borrowers who are employed by family or an interested party to
the property sale, purchase, or financing transaction must
provide:
• Verification of employment
• Most recent 2 years of personal tax returns, regardless of
percentage of ownership (if any) in business.
Most recent 2 years W2s; AND
• YTD paystub documenting at least 30 days of income.
• An IRS Form 4506T for all applicable tax returns for prior
years will be processed and transcripts used to verify
income documentation received.

23. Income that Requires Tax Returns
Employed by Family Owned Business or Transaction-Interested Party
Current income reported on VOE or paystub must be compared
with previous years to determine reasonability and likelihood of
continuance.
• Large, unexplained increases must be closely analyzed.
• The borrower is not required to have a two year work
history with this same company to make this
determination.
• If a borrower is recently employed with the family
owned/transaction-related party business, previous years’
earning ability should be compared with current salary
and the reasonability and likelihood of continuance
determined.

24. Income that Requires Tax Returns
Auto Allowance
Auto allowance cannot be used to offset a car payment.
Auto allowance may be used to qualify subject to the following
verifications:
• Payments have been received a minimum of 2 years; and
• The amount included for income is the amount received from
the employer less the amount of expenses the applicant has
deducted on IRS Form 2106.
• If the allowance is less than the expenses the loss must be
deducted from qualifying income.
• Written verification from the employer documenting the
allowance.
• The amount must be verified on a paystub.
• Income or loss must be averaged over a two year period.

25. Income that Requires Tax Returns
Clergy Member
• Ministers or other members of the clergy are generally
considered self-employed unless exempted by IRS from self-employment
taxes. An exception from the IRS must be
provided, when applicable.
• Rental or housing allowance received may be considered
income for qualifying the applicant.
• The church may budget for educational, medical insurance,
life insurance, retirement, etc. to be paid on behalf of
applicant; however, these items will not be considered as
qualifying income, unless exempted by the IRS.
• The housing allowance, although not subject to federal
income taxes, is subject to self-employment taxes. Gross
income on Schedule SE of the applicant’s 1040 should include
housing allowance paid

26. Income that Requires Tax Returns
Seasonal / Variable Income
• Income from seasonal employment may be considered if the
applicant has worked the same job “in season” for the past
two years and expects to be rehired for the next season. A
verification of employment (VOE) and the last two years (2) W-
2’s are required. The verification of employment must
reference the likelihood of borrower’s rehire. Seasonal income
from W-2’s and paystubs must be averaged over a two year
period.
• If the borrower’s income has come from multiple seasonal
employers, in related or unrelated fields, two years tax returns
must also be obtained as support for income. Seasonal
income from tax returns must be averaged over a two year
period.

27. Income that Requires Tax Returns
Truck Driver
• When a borrower is a truck driver, it is necessary to determine
whether the individual is a local, short-haul driver or an over-the-
road long haul driver. A long-haul driver will normally have
substantial non-reimbursed business expenses which should be
subtracted from income. Two years of tax returns must be
obtained to verify the amount of the business related
expenses. Long haul drivers may be paid either by the hour or
by the mile. Income must be averaged over a two year
period and not less than 18 months.
• Local and short-haul drivers do not typically incur business
expenses but are can also be paid by the hour or by the mile.
Consideration of possible expenses must be given when
qualifying these borrowers.

28. Income that Requires Tax Returns
Unemployment Benefits
• Unemployment income can be considered in stable monthly
income if it is common and customary for the borrower’s line
of work and likely to continue. The borrower must have a two
year history of receiving unemployment income along with a
two year history of seasonal income.
• Unemployment income is documented with two full years of
tax returns and income will be averaged over a two year
period.
• Unemployment income cannot be used for qualifying income
when the borrower underwent long periods of unemployment
(i.e. greater than 26 weeks) due to factors other than seasonal
employment.

29. Income that Requires Tax Returns
Union Employee
• Union workers are members of a specific trade union and are often
skilled tradesperson (e.g., electricians, plumbers, roofers, etc.).
Workers can work for a single employer on a long-term basis or for
more than one employer throughout the year. At the completion of
a job, the Union will then refer the individual to a new employer.
• Union workers jobs may be seasonal and it is not uncommon for
individuals to receive unemployment during down time.
• If the borrower is a member of a local trade union and obtains
employment via these means, income can be verified by the
following:
• 2 years tax returns, OR 2 years of W-2s, OR a VOE from the Union for
earnings from all employers during the current year and a W-2 from
prior year.
• Qualifying income is calculated using a two year average of
documented income.

30. Tax Transcripts – General Guidance
• The IRS transcripts should be reviewed for discrepancies that may
require additional documentation or re-calculation of income.
Additional reasons for discrepancies can include, but are not limited to:
o Capital gains/losses;
o Rental property income/losses; or
o Un-reimbursed employee expenses/Schedule 2106.
• In addition to reviewing the IRS transcripts for variances with income
documentation in file, the transcripts should be reviewed to identify
and address any additional discrepancies/red flags. These include, but
are not limited to:
o Undisclosed self-employment;
o Occupancy issues identified by address discrepancies;
o Undisclosed dependents; or
o Undisclosed rental and/or other properties.

31. Business Structures
• Knowledge of the structure of the business that a self-employed
borrowers has will assist the lender in evaluating the
stability of the business and the degree of the borrower’s
involvement.
• There are four principal business structures—
o sole proprietorships,
o partnerships,
o corporations, and
o “S” corporations.
• Note: An LLC can elect to be taxed as a sole proprietor,
partnership, S corporation or C corporation (as long as they
would otherwise qualify for such tax treatment), providing for
a great deal of flexibility.

32. Business Structures

33. Documentation Checklist
Sole Proprietorship
If the borrower receives income from a sole proprietorship, the
following documentation is required:
• U.S. FEDERAL 1040 with all applicable schedules attached,
• SCHEDULE C (Profit or Loss from Business),
• SCHEDULE D (Capital Gains & Losses),
• SCHEDULE F (Profit or Loss from Farming), and
• YEAR-TO-DATE PROFIT & LOSS STATEMENT, as applicable.

34. Personal Income Statements

35. Documentation Checklist
Partnership (General, Limited or LLC)
If the borrower is a partner in a general or limited partnership, or is
a limited liability company member, the following
documentation is required:
• U.S. FEDERAL 1040 with all applicable schedules attached,
• SCHEDULE E, PART II (Income or Loss from Partnerships),
• SCHEDULE K-1 (FORM 1065) (Partner’s Share of Income,
Deductions, Credits, etc.),
• FORM 1065 (U.S. Return of Partnership Income) with all
applicable schedules attached,
• YEAR-TO-DATE PROFIT & LOSS STATEMENT, as applicable, and
• PARTNERSHIP AGREEMENT (may be required).

36. Partnership Statements

37. Documentation Checklist
Corporation
If the borrower receives income from a corporation, the following
documentation is required:
• U.S. FEDERAL 1040 with all applicable schedules attached,
• FORM 1120 (U.S. Corporate Income Tax Return) with all
applicable schedules attached, and
• YEAR-TO-DATE PROFIT & LOSS STATEMENT, as applicable.

38. Corporate Statements

39. Documentation Checklist
S Corporation
If the borrower receives income from an S Corporation, the
following documentation is required:
• U.S. FEDERAL 1040 with all applicable schedules attached,
• SCHEDULE E, PART II (Income or Loss from S Corporations),
• SCHEDULE K-1 (FORM 1120S) (Shareholder’s Share of Income,
Deductions, Credits, etc.),
• FORM 1120S (U.S. Income Tax Return for an S Corporation) with
all applicable schedules attached, and
• YEAR-TO-DATE PROFIT & LOSS STATEMENT, as applicable.

40. S Corporation Statements

41. Flow of Tax Return Forms and
Supporting Schedules

42. Red Flags – Form 1040
• Borrower indicates self-employed, owner of a sole proprietorship, yet 1040’s
disclose wages, salaries, tips, etc.
• Business income is inconsistent with the net income on the Schedule C.
• Deductions were made for one-half self-employed health insurance for a
borrower who does not claim self-employment.
• Even dollar amounts for income or deductions.
• Evidence of whiteout or strikeovers, alterations or varied handwriting within
return.
• Handwritten tax returns prepared by a professional tax preparer.
• High-income borrower and self-prepared tax returns.
• High-income borrower with few or no deductions.
• Name, address, social security number, or corporation is inconsistent with
information in the loan file.
• No deductions have been taken or incorrect deductions have been taken.
• Obvious income/deduction calculations.
• Occupation differs from what was stated on the 1003.

43. Red Flags – Form 1040
• Paid tax preparer does not disclose tax ID.
• Paid tax preparer signs taxpayer’s copy.
• Personal information does not agree with the information in the loan file.
• Real Estate taxes paid, but no property shown on Schedule of Real Estate.
• Schedules missing from file.
• Self-employed borrower that does not reflect estimated tax payments
(Schedule SE).
• Self-employed borrower who shows salaried wages instead of business
income.
• Tax returns are not signed/dated by borrower.
• The number of dependents does not agree with the 1003.
• The type of handwriting varies within the return.
• Unemployment compensation was claimed but the file does not show a gap
in employment or that there is seasonal employment.
• W-2 information does not match the figures reported on the 1040.

44. Red Flags – Schedule A
• Borrower pays large amounts of interest, but few creditors are shown on the
mortgage application or credit report.
• Real estate owned, but no deductions taken for real estate taxes or mortgage
interest paid.
• Real estate taxes or mortgage interest reported, but no real estate owned.

45. Red Flags – Schedule B
• Stock owned, but no dividend income reported.
• Interest income reported is not consistent with cash assets in the bank.
• Source and/or amount of income are inconsistent with loan application.

46. Red Flags – Schedule C
• Borrower’s wages are paid, but no tax expense is claimed.
• Business expenses are not consistent with the type of business (i.e., truck driver
doesn’t claim a car or truck expense).
• Depreciation deduction for real estate, but ownership of real estate is not
disclosed (vice versa).
• Income appears high for the type of business listed on schedule C.
• Income does not agree with total income on 1099 forms.
• Interest expense, but borrower does not disclose a related loan.
• No “cost of goods sold” on retail or similar type of business.
• No deduction for depreciation (usually some type of equipment that qualifies).
• No IRA or Keogh deduction.
• No salary expense to operate business.
• Numbers are incorrectly added.
• The borrower takes a depreciation deduction for real estate that is not disclosed
on the application.
• There are no deductions for tax and licenses.

47. Red Flags – Schedule E
• Properties listed not disclosed on the loan application.
• Borrower income/loss not disclosed on loan application.
• Mortgage interest deduction taken but debt is not disclosed on the loan
application.
• Net income is inconsistent with amount disclosed on loan application.
• Partnership(s) and/or S Corporation(s) listed on Schedule E Part II and there is
no reference listed on the loan application.

48. Income Calculation Worksheet
• Many people are under the misconception that investors
require a specific cash flow work sheet be used. In fact,
Fannie Mae, Freddie Mac and most investors have no
requirement about what form to use when underwriting the
self-employed borrower.
• What is required by both Fannie Mae and Freddie Mac, and
almost all investors, is that the lender clearly shows how
income was determined.
• The form you use is up to you – it’s either dictated by your
investor guidelines, company policy or your comfort level with
one method or the other.

49. Income Calculation Worksheet
ADJUSTED GROSS INCOME (AGI)
• Start with the Total Income amount that appears on Line 22.
• The total income that appears here includes income and loss
from supporting schedules.
• As you analyze the tax return, you will add or subtract from this
total income, depending on the types of revenue and
expenses you find.

50. Income Calculation Worksheet
SCHEDULE ANALYSIS METHOD (SAM)
• Start with the amount that appears on Line 7: Wages, Salaries,
Tips, etc.
• As you analyze the tax return, you will also review separate tax
schedules filed by the borrower, such as Schedule A, Itemized
Deductions or Schedule C, Profit or Loss from Business.
• Because the income or loss is listed separately on each
schedule, you can clearly evaluate the level and stability of
the different sources of income.
• Consequently, you will add income or subtract
losses/expenses from the amount on Line 7.