Wednesday, November 5, 2008

Calculating Income for a Sole Proprietor

We are often asked how a lender calculates income for a borrower who has their own business and reports that income on IRS Form Schedule C (used for sole proprietorships). It's really very easy to do. Here are the Fannie Mae guidelines:

"The income (or loss) from a borrower’s sole proprietorship business is calculated on the Profit or Loss from Business (Schedule C) and transferred to IRS Form 1040. However, the lender may need to make certain adjustments to the net profit or loss shown on Schedule C to arrive at the borrower’s cash flow. For example, Schedule C may include income that was not obtained from the profits of the borrower’s business. If the lender determines that such income is not recurring, it should adjust the borrower’s cash flow by deducting the nonrecurring income. In addition, the lender may add back to the borrower’s cash flow any deductions the borrower took on Schedule C for depreciation, depletion, business use of a home, amortization, or casualty losses. The lender should deduct from the borrower’s cash flow any exclusion for meals and entertainment expenses that the borrower reported on Schedule C."

There is a form that we complete and send to the underwriter along with the tax returns. For each of the last two years, we start with the borrower's net income, and then add or subtract the items listed above. The bottom line is the amount we can use for income for each year. The income is then averaged over the last two years, and that average is the amount that the underwriter will consider as income. The income must also be stable or increasing from year to year.

The two-year average is an underwriting guideline, but it's important to remember guidelines are meant to guide the underwriters and are not etched in stone. Fannie Mae allows the underwriter to exercise some discretion. If the rest of the loan file is strong enough (good credit, good income, good reserves, etc.), then the loan may be approved with less than 24 months of self-employment. One of the biggest mistakes real estate agents and borrowers make is assuming that a loan will not be approved. It's always best to get a definitive answer from an underwriter.

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