Two-Year Tax Return Requirement
Fannie Mae and Freddie Mac require two years of complete federal tax returns for self-employed borrowers, including all schedules. For sole proprietors, this means Form 1040 with Schedule C. For S-corporation owners, this includes the personal 1040 plus the business return (Form 1120S) with Schedule K-1. For partnership interests, the personal return plus Form 1065 and K-1 are required .
FHA follows similar guidelines under HUD Handbook 4000.1, requiring two years of tax returns and evidence of business viability. VA loans also require two years of self-employment history, though exceptions may exist for borrowers transitioning from employed to self-employed in the same field .
How Underwriters Calculate Self-Employment Income
The underwriter begins with the net profit figure from the tax return, not gross revenue. For a Schedule C sole proprietor, net profit is found on Line 31 of Schedule C. The underwriter then adds back certain non-cash deductions that did not represent actual cash expenditures. Depreciation (Line 13) and depletion (Line 12) are the most common add-backs. Amortization of certain expenses and non-recurring losses may also be added back, depending on the circumstances.
For S-corporation and partnership income, the calculation begins with the borrower’s share of ordinary business income from the K-1, then adds back depreciation and other non-cash items from the business return. The underwriter also examines distributions versus retained earnings, and if the business is retaining a significant portion of income, the retained amount may not be available for qualification unless the borrower has a controlling interest and can access the funds .
Declining Income Analysis
When the most recent year’s income is lower than the prior year, the underwriter must determine whether the decline represents a trend. Fannie Mae requires the underwriter to evaluate the reason for the decline and determine whether the income level is stable, increasing, or decreasing. If income has declined more than 20% year-over-year, most lenders will use only the most recent year’s income or may require additional documentation such as a current profit and loss statement and business bank statements to demonstrate that the decline has stabilized or reversed .
A year-over-year decline does not automatically disqualify a borrower, but it shifts the burden to the borrower to demonstrate that the lower income level is sustainable and sufficient for the proposed mortgage payment.
Write-Offs and Qualifying Income
The most common frustration for self-employed borrowers is discovering that tax deductions which reduce their tax liability also reduce their qualifying income. A borrower who earns $200,000 in gross revenue but reports $90,000 in net income after deductions qualifies based on $90,000, not $200,000. Vehicle expenses, home office deductions, meals, travel, equipment purchases, and other legitimate business deductions all reduce the qualifying income figure.
Borrowers planning to purchase a home within the next one to two years should work with both a CPA and a mortgage professional to understand the trade-off between tax savings and mortgage qualification. Reducing deductions in the year or two before applying can materially increase qualifying income, though this must be balanced against the additional tax liability.
Related topics include foreign national and non-permanent resident mortgage options, recent job change, relocation, and employment gaps, buying a home with significant student debt, and special borrower situations: a decision guide.