B3-3.2-01, Underwriting Factors and Documentation for a Self-Employed Borrower (12/13/2023)

When determining the appropriate qualifying income for a self-employed borrower, it is important to note that business income (specifically from a partnership or S corporation) reported on an individual IRS Form 1040 may not necessarily represent income that has actually been distributed to the borrower. The fundamental exercise, when conducting a self-employment income cash flow analysis, is to determine the amount of income that can be relied on by the borrower in qualifying for their personal mortgage obligation. When underwriting these borrowers, it is important to review business income distributions that have been made or could be made to these borrowers while maintaining the viability of the underlying business. This analysis includes assessing the stability of business income and the ability of the business to continue to generate sufficient income to enable these borrowers to meet their financial obligations.

Any individual who has a 25% or greater ownership interest in a business is considered to be self-employed.

The following factors must be analyzed before approving a loan for a self-employed borrower:

• the stability of the borrower’s income,

• the location and nature of the borrower’s business,

• the demand for the product or service offered by the business,

• the financial strength of the business, and

• the ability of the business to continue generating and distributing sufficient income to enable the borrower to make the payments on the requested loan.

Fannie Mae generally requires lenders to obtain a two-year history of the borrower’s prior earnings as a means of demonstrating the likelihood that the income will continue to be received.

However, the income of a person who has less than a two-year history of self-employment may be considered, as long as the borrower’s most recent signed personal and business federal income tax returns reflect a full year (12 months) of self-employment income from the current business. The loan file must also contain documentation to support the history of receipt of prior income at the same (or greater) level and 

• in a field that provides the same products or services as the current business, or
• in an occupation in which they had similar responsibilities to those undertaken in connection with the current business.

In such cases, the lender must give careful consideration to the nature of the borrower’s level of experience, and the amount of debt the business has acquired.

The lender may verify a self-employed borrower’s employment and income by obtaining from the borrower copies of their signed federal income tax returns (both individual returns and in some cases, business returns) that were filed with the IRS for the past two years (with all applicable schedules attached).

Alternatively, the lender may use IRS-issued transcripts of the borrower’s individual and business federal income tax returns that were filed with the IRS for the most recent two years—as long as the information provided is complete and legible and the transcripts include the information from all of the applicable schedules. (See B3-3.1-06, Requirements and Uses of IRS IVES Request for Transcript of Tax Return Form 4506-CB3-3.1-06, Requirements and Uses of IRS IVES Request for Transcript of Tax Return Form 4506-C.)

The lender may provide one year of personal and business tax returns if the following requirements are met:

• the business from which the borrower is using self-employed income must have been in existence for five years as reflected on the Form 1003, and the borrower has had an ownership share of 25% or more for the past five years consecutively, and 

  • for partnerships, S corporations and corporations, the federal income tax return for the business must support the information reflected on the Form 1003. If the business was in existence prior to the borrower having 25% or more ownership, then the lender must demonstrate the borrower has had 25% or more ownership for at least five years consecutively.

  • for sole proprietorships, the individual federal tax return and any other documentation or information received must support the information reflected on the Form 1003 for the number of years the business has been in existence.

• all businesses are assessed separately for the five-years in existence benchmark and the number of years of personal and federal income tax returns required could differ when there are multiple self-employment income sources. 

• the lender must complete Fannie Mae’s Cash Flow Analysis (Form 1084) or any other type of cash flow analysis form that applies the same principles. A copy of the written analysis must be included in the permanent loan file.

Note: Alternative documentation to establish the number of years the borrower has ownership of 25% or more in a business may be obtained as long as the documentation clearly identifies the specific business listed on the Form 1003 and is supported by the most recent year tax returns. Documentation must be obtained through a reliable source, such as an IRS-Issued Employer Identification Number Confirmation letter, business license, articles of incorporation, or partnership agreements.

When two years of signed individual federal tax returns are provided, the lender may waive the requirement for business tax returns if:

• the borrower is using personal funds to pay down payment and closing costs and satisfy applicable reserve requirements,
• the borrower has been self-employed in the same business for at least five years (requirements noted above), and
• the borrower's individual tax returns show an increase in self-employment income over the past two years from the respective business.

The lender must prepare a written evaluation of its analysis of a self-employed borrower’s personal income, including the business income or loss, reported on the borrower’s individual income tax returns. The purpose of this written analysis is to determine the amount of stable and continuous income that will be available to the borrower. This is not required when a borrower is qualified using only income that is not derived from self-employment and self-employment is a secondary and separate source of income (or loss). Examples of income not derived from self-employment include salary and retirement income.

The lender may use Cash Flow Analysis ( Form 1084), another type of cash flow analysis, or an automated tool such as Fannie Mae-approved vendor tools or the  Income Calculator, that apply the same principles as Form 1084. A copy of the written analysis and conclusions or the Findings Report generated by Income Calculator must be retained in the loan file.

The lender may receive representation and warranty enforcement relief of the calculated amount if certain requirements are met. See A2-2-04, Limited Waiver and Enforcement Relief of Representations and WarrantiesA2-2-04, Limited Waiver and Enforcement Relief of Representations and Warranties  for additional information. 

When a borrower is relying upon self-employed income to qualify for a loan and the requirements that permit the lender to waive business tax returns are not met, the lender must prepare a written evaluation of its analysis of the borrower’s business income. The lender must evaluate the borrower’s business through its knowledge of other businesses in the same industry to confirm the stability of the borrower’s business income and estimate the potential for long-term earnings.

The purpose of this analysis is to:

• consider the recurring nature of the business income, including identification of pass-through income that may require additional evaluation;

• measure year-to-year trends for gross income, expenses, and taxable income for the business;

• determine (on a yearly or interim basis) the percentage of gross income attributed to expenses and taxable income; and

• determine a trend for the business based on the change in these percentages over time.

The lender may use Fannie Mae’s Comparative Income Analysis (Form 1088), Fannie Mae's  Income Calculator, or any other method of trend analysis that enables it to determine a business’s viability, as long as the method used fairly presents the viability of the business and results in a degree of accuracy and a conclusion that is comparable to that which would be reached by use of Form 1088.

A copy of the written analysis and conclusions or the Findings Report generated by Income Calculator must be retained in the loan file.

The lender may use  Income Calculator  to calculate the monthly qualifying income from self-employment. Income Calculator will provide a complete analysis of self-employment income for each borrower on a business-by-business basis and produce a Findings Report. This tool can be used for loans underwritten manually or loan casefiles submitted to DU.

The Income Calculator Findings Report summarizes the overall qualifying income amount, trending analysis, business liquidity, and provides specific messaging for each business evaluation. These detailed messages are designed to assist lenders in processing and underwriting self-employed borrowers while providing certainty of the income calculation. See  B3-3.1-10, Income CalculatorB3-3.1-10, Income Calculator for additional information.

When a borrower is using self-employment income to qualify for the loan and also intends to use assets from their business as funds for the down payment, closing costs, and/or financial reserves, the lender must perform a business cash flow analysis to confirm that the withdrawal of funds for this transaction will not have a negative impact on the business. To assess the impact, the lender may require a level of documentation greater than what is required to evaluate the borrower’s business income (for example, several months of recent business asset statements in order to see cash flow needs and trends over time, or a current balance sheet). This may be due to the amount of time that has elapsed since the most recent tax return filing, or the lender’s need for information to perform its analysis. See  B3-4.2-02, Depository AccountsB3-4.2-02, Depository Accounts, for requirements when self-employment income is not being used to qualify, but business assets are being used for the down payment, closing costs, and/or financial reserves.

When co-borrower income that is derived from self-employment is not being used for qualifying purposes, the lender is not required to document or evaluate the co-borrower’s self-employment income (or loss). Any business debt on which the borrower is personally obligated must be included in the total monthly obligations when calculating the debt-to-income ratio.

For requirements regarding verbal VOEs, see  B3-3.1-07, Verbal Verification of EmploymentB3-3.1-07, Verbal Verification of Employment.