FHA Self Employed Borrower

A borrower is considered self-employed when they have 25% or more ownership interest in a business. As long as income is considered stable and continuing it can be used to qualify for a loan. For the income to be considered as stable, FHA typically requires a 2 year history (2 full years of income tax returns are used for verification).

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Documentation requirements:

· Individual tax returns (W-2 forms and 1099 forms, along with all schedules), for the past 2 years. Tax returns must be signed and dated.
· Business income tax returns (with all schedules) for the past 2 years, if the business is a Partnership, Corporation, or “S” Corporation. Business tax returns must also be signed.
· A Profit and Loss statement and balance sheet (year to date). This is completed and executed by the borrower.

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Analysis of Income:

· To obtain the most accurate picture of income and expenses the earnings trend is averaged over the past 2 years. The income tax return information will be evaluated in conjunction with the year to date income information. Year to date income which is higher will not be used.
· The economic forecast for the business type and the financial strength of the individual business must be examined. In evaluating this annual earnings that demonstrate stable or increasing income are acceptable, but earnings that are declining are not.

Tax return analysis:

Individual 1040 return:

· Schedule C: If the business is a sole proprietorship, the borrower’s personal and business liability are the same. Depletion and depreciation can be added back to Adjusted Gross Income (AGI). (NOTE: Any W-2 income resulting from anyone other than the borrower must be subtracted from the AGI on the 1040).
· Schedule E: This includes income earned from rents, royalties, partnerships, etc. Depreciated can be added back into AGI.
· Schedule D: Shows capital loss or gain. Generally these reflect a one-time transaction and should not be used to determine income. However, if the turnover of assets resulting from a gain or loss of income is constant , any positive or negative income can be used as long as 3 years of current tax returns shows the figure as constant over the 3 year period.
· Schedule B: Shows interest and dividend income. In order to be added into the AGI, this income
(whether taxable or tax-exempt) must have been received for the past 2 years and must be expected to continue for at least 3 more years.
· Other schedules: AGI may include depreciation shown on Schedule F. The non-taxable portion of IRA distributions, Pensions & Annuities, and Social Security benefits may be added to the AGI as long as the benefit is proven to continue for at least 3 years. Other adjustments that can be added back into the AGI include: Keogh, IRA, health insurance deductions, and alimony payments. The employee business expenses listed on Form 2016 are to be deducted from the AGI.

Corporate Tax Returns (Form 1120):

Since corporations are owned by stockholders any owner’s compensation is shown on not only the corporation’s tax returns but also on the owner’s individual tax return. If the corporation’s tax return does not show the borrower’s percentage of ownership, then this information must be procured from the corporation’s accountant. The borrower’s access to the funds must also be confirmed with the accountant.

The Adjusted Business Income must first be determined and then multiplied by the borrower’s ownership percentage.

The following are the adjustments that must be made to the adjusted business income when analyzing corporate returns:
· Taxable income: this refers to the corporation’s net income before taxes are calculated or paid. The tax amount must be deducted from the taxable income.
· Depreciation and depletion: this is added back to “after tax” income
· Fiscal year vs. Calendar year: If the corporations fiscal year (operating year) does not match the actual calendar year, an adjustment must be made to relate to the correct percentage of income used.
· Cash withdrawals: Anytime cash is withdrawn by the borrower from the company for personal use, the negative impact on the business’s ability to operate must be ascertained.

“S” Corporations (Form 1120S):

Gains or losses in the company income are passed on to the stockholders (owners) in proportion to their ownership percentage.

Any income generated from the business to the owner (borrower) is reported on a W-2 and the individual pays taxes on his/her form 1040.

Depreciation and depletion are added back into the income according to the percentage of ownership in the business.

The borrower’s percentage of obligation in regards to any debts to be paid by the corporation in the subsequent year must be reduced from income.

The negative effect on the business resulting from the borrower withdrawing cash must be examined. It must be found that the business still has sufficient income to continue operating at a stable rate.

Partnerships (Form 1065):

When at least 2 individuals form a business and share the profits, losses, and responsibility of the company, a partnership is formed.

Each individual partner in responsible for paying taxes on their share of the net partnership income.

To ascertain the viability of the business, the form 1065 must be examined. The individual’s share of the income will be reflected on schedule E of the individual’s 1040.
Depreciation and Depletion are added back into the income, in proportion to the individual’s percentage of ownership.

The partnerships obligations and debts due within a year will be deducted from the individual’s share of the partnership income.

It must be verified that the individuals cash withdrawals have no negative impact on the partnership’s ability to operate in the future.