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Self-Employed Income Calculation

Self-employed income calculation is the underwriting process used to determine a self-employed borrower's qualifying income from business tax returns. Lenders analyze net profit after business expenses, apply adjustments for non-cash deductions, average income over two years, and evaluate business stability to arrive at a monthly qualifying figure.

Key Takeaways

  • Lenders use net income from tax returns, not gross business revenue, as the starting point for self-employed income calculation.
  • A minimum two-year history of self-employment is generally required, with both years of personal and business tax returns reviewed.
  • Non-cash expenses such as depreciation and amortization may be added back to qualifying income, partially offsetting the impact of business deductions.
  • Declining income between year one and year two is a serious underwriting concern and may result in using only the lower year or denying the application.
  • Business structure (sole proprietorship, partnership, S-corp, C-corp) determines which tax forms and schedules the lender analyzes.
  • Borrowers who aggressively minimize taxable income through write-offs simultaneously reduce their mortgage qualifying income.

How It Works

Sole Proprietorship (Schedule C)

Sole proprietors report business income and expenses on IRS Schedule C, which is filed as part of the personal Form 1040. The lender begins with Line 31 (net profit or loss) from each of the two most recent years. From there, the underwriter performs a cash flow analysis that adds back non-cash expenses. Depreciation (Line 13) and depletion (Line 12) are the most common add-backs. Amortization and casualty losses reported on Schedule C may also be added back if they are non-recurring.

Business use of home deductions are generally added back because they represent expenses the borrower would incur regardless of the business. Meals and entertainment deductions, which are already limited by tax rules, are typically left as-is. The resulting adjusted net income for each year is then averaged to produce the monthly qualifying figure. If Year 1 adjusted net income is $68,000 and Year 2 is $74,000, the qualifying monthly income would be ($68,000 + $74,000) / 24 = $5,917.

Partnerships and LLCs (Form 1065 / Schedule E)

Partners and members of multi-member LLCs receive a Schedule K-1 from Form 1065. The borrower’s share of ordinary business income (or loss) flows to their personal Schedule E. Lenders review the K-1 to identify the borrower’s distributive share and then examine the partnership return itself for additional factors. Key items include the borrower’s percentage of ownership, whether distributions are consistent with reported income, and whether the partnership has sufficient liquidity to continue operations.

Guaranteed payments to the borrower are included as qualifying income. However, if the partnership shows an overall loss or the borrower’s capital account is declining, the lender may reduce qualifying income or question the viability of the business. Non-cash deductions at the partnership level (depreciation, amortization) may be added back proportionally based on the borrower’s ownership percentage.

S-Corporation (Form 1120S / Schedule E)

S-corporation shareholders who are also employees of the corporation present a dual income picture. The borrower receives W-2 wages from the S-corp (reported on the personal return) plus their share of the corporation’s net income or loss via Schedule K-1 from Form 1120S. Both components are included in the qualifying calculation.

The lender reviews the corporate return to assess business health. If the S-corp shows a net loss after the borrower’s compensation, that loss may reduce qualifying income below the W-2 salary alone. For example, if the borrower takes $120,000 in W-2 wages but the S-corp reports a $30,000 net loss on the K-1, the effective qualifying income may be $120,000 minus $30,000 = $90,000 annually, depending on the borrower’s ownership percentage .

The Two-Year Average and Trending Analysis

After calculating adjusted net income for each of the two tax years, the lender compares them. If income is stable or increasing, the two years are averaged. If income is declining by more than a modest percentage, the lender faces a decision point. A small decline may result in using the lower year alone rather than the average. A significant decline, often defined as greater than 20% , may result in using only the most recent year’s lower figure, requiring a written explanation from the borrower, or denying the application if the trend suggests the business is contracting.

Lenders may also request a year-to-date profit and loss statement, prepared and sometimes signed by a CPA, to determine whether the current year’s income is on track relative to the prior years. If the YTD P&L shows further decline, the underwriter has additional cause for concern.

Related topics include mortgage lenders calculate income, bank statement loans explained, 1-year vs 2-year tax return mortgages, 1099 income mortgage rules, profit & loss statements for mortgage qualification, and debt-to-income ratio explained (dti).

Key Factors

Factors relevant to Self-Employed Income Calculation
Factor Description Typical Range
Business Type / Tax Structure The legal structure of the business determines which IRS forms and schedules are used for income calculation. Different structures have different add-back rules. Sole proprietorship (Schedule C), Partnership (Form 1065/K-1), S-Corp (Form 1120S/K-1), C-Corp (Form 1120).
Years in Business Most lenders require a minimum of two years of self-employment history documented by tax returns. Fewer than two years generally disqualifies the income from conventional programs. Minimum 2 years required for most conventional and government programs. Some non-QM lenders accept 1 year .
Income Trend (Declining vs. Increasing) Year-over-year change in net business income is closely scrutinized. Declining trends reduce qualifying income and may lead to denial. Stable or increasing: 2-year average used. Decline under 20%: lower year may be used. Decline over 20%: heightened scrutiny or denial .
Write-Off Impact Business deductions that reduce taxable income simultaneously reduce mortgage qualifying income. Non-cash deductions (depreciation, amortization) may be added back. Common add-backs include depreciation, depletion, amortization, and business use of home. Meals, supplies, and other cash expenses are not added back.
Ownership Percentage For partnerships and S-corps, the borrower's ownership share determines how much of the business income or loss flows to qualifying income. 25% or greater ownership typically triggers full business return review by the lender .

Examples

Sole Proprietor with Consistent Income

Scenario: A freelance graphic designer has been self-employed for five years. Schedule C shows net profit of $82,000 in the prior year and $78,000 in the most recent year. Depreciation on equipment was $4,500 each year. No other non-cash deductions.
Outcome: Adjusted income Year 1: $82,000 + $4,500 = $86,500. Adjusted income Year 2: $78,000 + $4,500 = $82,500. Two-year average: ($86,500 + $82,500) / 24 = $7,042 per month. The slight decline is within acceptable range and does not trigger a trending concern.

S-Corp Owner with Corporate Loss

Scenario: A borrower owns 100% of an S-corporation and takes $95,000 in W-2 salary. The S-corp's Form 1120S shows a net ordinary loss of $22,000 after the borrower's compensation. The K-1 passes this loss to the borrower.
Outcome: Qualifying income: $95,000 W-2 salary minus $22,000 K-1 loss = $73,000 annually, or $6,083 per month. The corporate loss reduces the borrower's qualifying income below the W-2 figure alone. If the loss has been increasing year over year, additional scrutiny applies.

Partnership Member with Guaranteed Payments

Scenario: A borrower holds a 40% interest in a consulting partnership. The K-1 shows $45,000 in ordinary income (40% share) plus $60,000 in guaranteed payments. The partnership's depreciation totals $30,000.
Outcome: Ordinary income share: $45,000. Guaranteed payments: $60,000. Depreciation add-back (40% of $30,000): $12,000. Total adjusted income for the year: $117,000. This figure is averaged with the prior year to determine the qualifying monthly amount.

Common Mistakes to Avoid

  • Confusing gross business revenue with qualifying income

    A business that generates $400,000 in revenue but reports $280,000 in expenses yields only $120,000 in net income for mortgage purposes. Borrowers who quote gross revenue to loan officers create unrealistic expectations about their purchasing power.

  • Maximizing tax deductions in the years before applying for a mortgage

    Every dollar deducted on the business tax return is a dollar subtracted from qualifying income. Borrowers planning to apply for a mortgage within the next one to two years should discuss with their CPA whether it makes sense to reduce discretionary write-offs during that period.

  • Filing tax returns late or requesting extensions without understanding the impact

    Lenders require filed tax returns. If extensions are filed and the returns are not yet available, the lender cannot complete the income calculation. Borrowers should file returns before applying for a mortgage if at all possible. Tax transcripts from the IRS (Form 4506-C) must match the returns provided.

  • Ignoring the impact of a declining income trend

    If net business income dropped significantly from the prior year to the most recent year, the lender will not simply average the two years. The underwriter may use only the lower figure or decline to approve the loan. Borrowers should review their own two-year income trend before applying.

Documents You May Need

  • Personal federal tax returns (Form 1040) with all schedules for the past two years
  • Business tax returns (Schedule C, Form 1065, or Form 1120S) for the past two years
  • Year-to-date profit and loss statement (may need CPA preparation or signature)
  • Business license or registration documentation
  • Two most recent months of business and personal bank statements
  • IRS Form 4506-C signed for tax transcript verification
  • CPA letter confirming business status and ownership percentage (if requested)
  • Schedule K-1 forms for the past two years (partnerships and S-corps)

Frequently Asked Questions

How do lenders calculate self-employed income differently from W-2 income?
W-2 income is based on gross earnings before personal deductions. Self-employed income is based on net profit after business expenses as reported on tax returns. Lenders then apply add-backs for non-cash deductions like depreciation. The result is typically lower than gross business revenue, which is why self-employed borrowers often qualify for less than W-2 employees with similar total earnings.
Can I qualify with only one year of self-employment history?
Most conventional and government loan programs require two full years of self-employment documented by tax returns. Some non-QM (non-qualified mortgage) programs may accept one year, but these typically carry higher interest rates and require larger down payments. One year of self-employment is generally insufficient for Fannie Mae, Freddie Mac, FHA, or VA loans .
What is a depreciation add-back and why does it matter?
Depreciation is a non-cash tax deduction that reduces taxable income on paper without requiring an actual cash expenditure in the current year. Because it does not affect the borrower's real cash flow, lenders add it back to net income when calculating qualifying income. This add-back can meaningfully increase the qualifying figure for borrowers with significant depreciable assets such as vehicles, equipment, or commercial property.
Does my business need to be profitable to qualify for a mortgage?
Generally, yes. If the business shows a net loss on tax returns, that loss can reduce or eliminate qualifying income. For S-corp owners who take a W-2 salary, a corporate loss on the K-1 is subtracted from the salary figure. A business that consistently operates at a loss presents a significant underwriting challenge.
How does an S-corp salary affect my mortgage qualification?
S-corp owners who are also employees receive W-2 wages from the corporation plus a share of the company's net income or loss via K-1. Both are combined for qualification purposes. If the S-corp shows a net loss after the owner's salary, that loss reduces qualifying income below the W-2 amount. Lenders review the full corporate return to assess business viability.
What if my income increased significantly in the most recent year?
Increasing income is viewed favorably. Lenders will typically average the two years, which means the higher recent year is blended with the lower prior year. In some cases, if the increase is substantial, the lender may ask for a year-to-date P&L to confirm the upward trend is continuing. The average will still be lower than the most recent year's income alone.
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