Written By: NAMU® Op-Ed Ghost Writer
In December 2014, Fannie Mae issued a selling guide update regarding the required methods for analyzing self-employed borrowers whose income is reported on Schedule K-1 for S-corporations or Partnerships. In August 2015, Fannie Mae issued a selling guide update that delayed the implementation of these new rules until February 2016. On June 28, 2016 Fannie Mae issued another update which clarified some of the policies outlined in the original selling guide update from 2014. As a result, it is now mandatory that all lenders begin to analyze self-employed income utilizing these new rules.
The newest guidelines bring several new points to the analysis of self-employed borrowers. NAMU highly recommends all mortgage origination professionals refer to the selling guide sections and selling guide announcements listed at the end of this article for reference. Reviewing these updates is critical to developing complete comprehension and full compliance with the new rules.
First, when reviewing all forms of self-employment income, the Fannie Mae Form 1088 Comparative Income Analysis should be completed to determine the business’s viability. This form will demonstrate the business’s earnings trend and verify that income is stable or increasing. A copy of this, or a similar form, must be retained in the mortgage file.
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Second, when analyzing K-1 income, the most conservative approach is to qualify the borrower using only the cash distributions issued to the borrower over the previous two years. If this income is consistent and stable over the past two years and sufficient to meet an acceptable qualifying debt ratio, no further analysis is required. This same rule can be applied when using guaranteed payments to the partner. However, lenders should attempt to qualify the borrower using cash distributions only before adding in guaranteed payments to the partner.
If A) the cash distributions are not stable, or B) the stable and consistent cash distributions and/or guaranteed payments to the partner are not sufficient to qualify the borrower, ordinary business income and other net distributions listed on the K-1 may be utilized. However, utilization of these other distributions requireconfirmation of business liquidity. Business liquidity is determined with one of two ratios: the Quick Ratio, or the Current Ratio. These ratios measure the amount of assets available per $1.00 of liabilities. For example, if a ratio is 2.0, then it can be said we have $2.00 in assets for every $1.00 of liabilities. The ratio would be expressed as 2:1.
The Quick Ratio is calculated as follows: (current assets – inventory) / current liabilities
The Current Ratio is calculated as follows: current assets / current liabilities
The Quick Ratio should be used for businesses that rely heavily on inventory to generate income.Whereas the Current Ratio is more appropriate for service businesses or those which do not rely on inventory for income.
Please note: if the income amount listed on the ordinary business income line is equal to the amount listed as cash distributions, the lender may use the cash distribution amount and waive the liquidity calculation requirement. However, if the cash distributions over the past two years are not stable and consistent, and the lender still wishes to use this income to qualify, liquidity must be developed.
As a reminder, lenders must also provide verbal verification of employment for self-employed borrowers within 30 calendar days prior to the note date. This verification can come in the form of third party confirmation (CPA letter, business license, etc.), or a phone and address listing from the internet.
FNMA Selling Guide Sections and Selling Guide Announcements for reference:
• B3-3.1-07: Verbal Verification of Employment
• B3-3.1-09: Other Source of Income (Schedule K-1 Income)
• B3-3.2-01: Underwriting Factors and Documentation for a Self-Employed Borrower
• B3-3.2.1-08: Income or Loss Reported on IRS Form 1065 or IRS Form 1120S, Schedule K-1 (Income or Loss Reported on IRS Form 1065 or IRS Form 1120S, Schedule K-1)
• B3-3.2.2.-01: Analyzing Partnership Returns for a Partnership or LLC (Income from Partnerships, LLCs, Estates, and Trusts)
• B3-3.2.2.-02, Analyzing Returns for an S Corporation (Borrower’s Proportionate Share of Income or Loss)
• FNMA Selling Guide Announcement SEL-2016-05
• FNMA Selling Guide Announcement SEL-2015-09
• FNMA Selling Guide Announcement SEL-2014-16
About The Author
All of NAMU® op-ed writers range from veteran mortgage processing & underwriting instructors for CampusUnderwriter (www.MortgageUnderwriter.org) to mortgage industry professionals. Some have conducted numerous mortgage processing & underwriting training classes and have worked in the mortgage banking industry on average 15+ years. If you're interested in becoming a writer for NAMU®, please email us at: contact@mortgage-underwriters.org
