MortgageLoans.net

1-Year vs 2-Year Tax Return Mortgages

The 1-year vs. 2-year tax return distinction refers to the number of years of federal tax returns a mortgage lender requires to verify income. While two years is the standard, certain borrowers with stable W-2 employment may qualify with one year under specific agency guidelines. Self-employed borrowers and those with variable or declining income typically require two full years.

Key Takeaways

  • Two years of tax returns is the standard documentation requirement for most mortgage programs, but it is not an absolute rule in all cases.
  • Fannie Mae guidelines permit one year of tax returns for W-2 employees when income is stable, employment history is consistent, and the underwriter can establish continuity .
  • Self-employed borrowers almost always require two full years of personal and business tax returns, regardless of other factors.
  • Declining income between Year 1 and Year 2 typically requires the lender to use the lower year or the most recent 12 months, even when two years are provided.
  • Lender overlays may impose stricter requirements than agency minimums. A lender may require two years even when agency guidelines would accept one.
  • Recent graduates entering a field related to their degree may receive special consideration for shorter employment and documentation histories.

How It Works

When One Year of Tax Returns May Be Sufficient

Under Fannie Mae guidelines, one year of federal tax returns may be acceptable when the borrower meets several conditions simultaneously. The borrower should be a W-2 employee (not self-employed) with a consistent employment history of at least two years in the same field or a related field. Income should be stable or increasing, with no gaps in employment exceeding 30 days that cannot be reasonably explained. The underwriter must be able to document income continuity and conclude that the income is likely to continue for at least three years.

In practice, the one-year scenario most commonly applies to borrowers who recently started a new W-2 position in the same industry at equal or higher pay, or to recent graduates who have entered a profession directly related to their degree. A nurse who worked at one hospital for three years and then moved to another hospital at higher pay eight months ago is a strong candidate for one-year documentation. The income type, career continuity, and upward trajectory all support the shorter documentation period.

When Two Years Are Mandatory

Two years of tax returns are required in nearly all cases involving self-employment income, variable income components (overtime, bonus, commission), rental income, or any income source that fluctuates. The rationale is straightforward: variable and self-employment income cannot be reliably projected from a single year’s snapshot. Two years of data allow the lender to calculate an average, identify trends, and assess stability.

Two years are also required when the borrower has gaps in employment, has changed careers (not just employers), has income from multiple sources, or when the first year of income is needed to establish a baseline for averaging. Borrowers who have been in their current position for less than two years but changed industries (for example, from teaching to software sales) will typically need two years of returns to demonstrate their income trajectory in the new field.

Declining Income Rules

When two years of tax returns are provided, the lender compares Year 1 to Year 2. If income has declined, the lender cannot simply average the two years and ignore the trend. Agency guidelines require the underwriter to address declining income explicitly. The typical approach depends on the magnitude of the decline.

For modest declines, the lender may use the lower of the two years rather than the average. For significant declines (often characterized as greater than 20%, though this threshold varies by investor and is subject to underwriter judgment ), the lender may require a written explanation, current-year income documentation (such as a year-to-date pay stub or P&L statement), or may deny the application if the trend suggests continuing deterioration. In some cases, the underwriter may request only the most recent 12 months of income if there is a reasonable explanation for the decline (such as a one-time business disruption).

Lender Overlays and Practical Reality

Agency guidelines establish the minimum requirements, but individual lenders often impose overlays that are more restrictive. A lender may require two years of tax returns for all borrowers regardless of employment type, income stability, or agency guidance. These overlays exist because the lender assumes the risk of repurchase if a loan defaults and the underwriting is later questioned.

Borrowers who believe they qualify under the one-year exception should confirm the specific lender’s policy before relying on it. Shopping among multiple lenders may be necessary to find one that follows agency guidelines without adding overlays that eliminate the one-year option.

Related topics include self-employed income calculation, bank statement loans explained, 1099 income mortgage rules, profit & loss statements for mortgage qualification, debt-to-income ratio explained (dti), and common income mistakes that cause mortgage denials.

Key Factors

Factors relevant to 1-Year vs 2-Year Tax Return Mortgages
Factor Description Typical Range
Employment Type Whether the borrower is a W-2 employee or self-employed is the primary determinant of how many years of returns are required. W-2 salaried: may qualify with 1 year. Self-employed: 2 years required in nearly all agency programs.
Income Trend Whether income is stable, increasing, or declining between the two tax years directly affects how the income is calculated and whether additional documentation is needed. Increasing: 2-year average used. Stable: 2-year average or most recent year. Declining: lower year or denial, depending on severity.
Loan Program Different agencies and loan programs have varying requirements. Conventional (Fannie/Freddie), FHA, VA, and non-QM programs each have their own documentation standards. Fannie Mae may allow 1 year for W-2 borrowers. FHA generally requires 2 years. Non-QM varies by lender .
Time at Current Employer How long the borrower has been in their current position affects whether the lender needs additional years of documentation to establish income stability. 2+ years at same employer strengthens 1-year case. Less than 1 year typically requires 2 years of returns plus employment history verification.
Career Continuity Whether the borrower has remained in the same field or changed industries. Same-field job changes are treated more favorably than career changes. Same field with pay increase: favorable for 1-year documentation. Industry change: 2 years typically required.

Examples

W-2 Employee Qualifying with One Year of Returns

Scenario: A registered nurse has worked in healthcare for seven years. She changed hospitals 10 months ago, receiving a pay increase from $78,000 to $88,000. She has her most recent year's tax return, current pay stubs, and a Verification of Employment from her current employer.
Outcome: The lender accepts one year of tax returns because the borrower has a long history in the same profession, income is increasing, and employment continuity is well established. Monthly qualifying income: $88,000 / 12 = $7,333. The prior year's lower income is not needed and would not negatively affect the calculation.

Self-Employed Borrower Required to Provide Two Years

Scenario: A self-employed plumber has operated his own business for four years. He wants to provide only his most recent year's tax return because it shows higher income than the prior year. Year 1 Schedule C net: $62,000. Year 2 Schedule C net: $81,000.
Outcome: The lender requires both years of returns. Self-employment income necessitates two-year documentation regardless of the trend direction. The two-year average is used: ($62,000 + $81,000 + depreciation add-backs) / 24. The borrower cannot elect to use only the higher year.

Declining Income Triggering Lower-Year Usage

Scenario: A sales manager earned $135,000 in Year 1 (salary plus commission) but only $108,000 in Year 2 due to a territory change. The decline is approximately 20%. The borrower provides both years' returns.
Outcome: The lender identifies the declining trend and uses the lower Year 2 figure of $108,000 rather than the two-year average of $121,500. The underwriter requests a letter of explanation and current-year pay stubs to determine if the decline is stabilizing. Monthly qualifying income: $108,000 / 12 = $9,000.

Common Mistakes to Avoid

  • Assuming one year of returns is automatically accepted because agency guidelines allow it

    Lender overlays frequently require two years of returns regardless of agency guidelines. A borrower who believes one year is sufficient should verify the specific lender's policy before providing documentation. Not all lenders follow the minimum agency standards.

  • Providing two years when the earlier year shows significantly lower income

    While borrowers cannot choose which returns to provide (lenders will request what they need), understanding that the two-year average may reduce qualifying income is important for setting expectations. A borrower who earned $50,000 in Year 1 and $90,000 in Year 2 will not qualify based on $90,000 if two years of averaging are applied.

  • Not recognizing that tax extensions delay the process

    If the borrower has filed an extension and the most recent year's return is not yet available, the lender may use the older return as the most recent, which can change the income calculation and trend analysis. Borrowers should file returns before applying whenever possible.

  • Failing to prepare documentation for income gaps or career changes

    Employment gaps, industry changes, or periods of reduced income in the two-year window will require explanation. Borrowers who can provide clear, documented explanations (such as returning to school, relocating, or recovering from an industry downturn) are better positioned than those who leave gaps unexplained.

Documents You May Need

  • Federal tax returns (Form 1040 with all schedules) for one or two years as required
  • W-2 forms for each year of returns provided
  • Most recent 30 days of pay stubs
  • Verification of Employment (VOE) from current employer
  • Written letter of explanation for any employment gaps exceeding 30 days
  • Business tax returns for two years (if self-employed)
  • Year-to-date profit and loss statement (if self-employed)
  • IRS Form 4506-C for tax transcript verification

Frequently Asked Questions

Can I get a mortgage with only one year of tax returns?
In certain circumstances, yes. Fannie Mae guidelines allow one year of tax returns for W-2 employees with stable employment in the same field, increasing or stable income, and a clear history of income continuity. Self-employed borrowers and those with variable income typically cannot qualify with only one year. Individual lender overlays may require two years regardless of agency guidelines.
Why do lenders require two years of tax returns?
Two years of returns allow lenders to calculate income averages, identify trends, and assess stability. A single year provides only a snapshot, which may not represent the borrower's typical earnings. Variable income, self-employment, and declining earnings all require the context that a second year provides.
What happens if my income declined from Year 1 to Year 2?
Declining income triggers additional scrutiny. Depending on the severity of the decline, the lender may use only the lower year's income instead of the two-year average, request a written explanation, require year-to-date income verification, or in cases of severe decline, deny the application. The underwriter must determine whether the decline is temporary or indicative of a continuing trend.
I just graduated and started my first job. How many years of returns do I need?
Recent graduates may receive favorable treatment under agency guidelines. If the new position is in a field related to the borrower's degree and the employment is salaried with stable compensation, one year of returns (or less, supplemented by an offer letter and pay stubs) may be acceptable. The lender evaluates the degree-to-career connection and the likelihood of income continuity.
Do lender overlays always require two years of returns?
Not always, but it is common. Many lenders apply overlays that exceed agency minimums, including requiring two years of returns for all borrowers. Borrowers who qualify under the one-year exception should confirm the specific lender's policy before submitting an application. Comparing requirements across lenders is often necessary.
Does the one-year exception apply to FHA or VA loans?
FHA and VA have their own documentation requirements that may differ from Fannie Mae and Freddie Mac guidelines. Generally, FHA requires two years of tax returns for self-employed borrowers and may accept one year for W-2 employees in specific circumstances. VA guidelines follow similar principles. Borrowers should confirm the specific requirements for their loan program .
Last updated: Reviewed by:

Related Topics