Schedule C Income for a Mortgage: What Lenders Add Back

How does a mortgage lender work out income from Schedule C?

A lender starts from the net profit on your filed Schedule C, then adjusts it into a cash-flow figure. It does not start from your books. Under Fannie Mae's Selling Guide, the rulebook for lenders that sell loans to it, the lender adds back depreciation, depletion, business use of home, amortization and casualty losses, and subtracts non-recurring income and the meals exclusion. So real deductions can cost less qualifying income than they look like they do.

To gather: signed federal returns for two years with every schedule, a year-to-date profit and loss statement, any Schedules K-1, and the bank statements a lender may ask for.

Those are Fannie Mae's rules. An FHA-insured loan follows HUD's own handbook, other programs have their own rules, and a lender may ask for more than the minimum documentation (Selling Guide B3-3.1-01). Ask which loan program and worksheet your lender uses before you change anything.

If a pre-approval came back lower than you expected and a closing date is set, read the add-back and amendment sections before you change the return or the books. Your case is also not simple if your income fell, you have been self-employed under two years, the income comes from an S corporation or partnership, your latest return is not filed, or your books and return disagree.

Which Schedule C deductions can a lender add back?

Fannie Mae tells the lender to add back five recurring items claimed on Schedule C: depreciation, depletion, business use of a home, amortization and casualty losses (Selling Guide B3-3.6-03). The lender records the analysis on Fannie Mae's Cash Flow Analysis (Form 1084) or an equivalent form (Selling Guide B3-3.5-01); ask which it used and what it added back. The IRS Schedule C instructions show where each item appears.

Line 13 combines depreciation and section 179 expensing, while the Selling Guide's wording is depreciation. Ask whether the lender adds back the whole line, especially after a large one-time equipment purchase. If you deduct the standard mileage rate, line 13 shows no depreciation for that vehicle, yet depreciation is built into the rate (Publication 463). Keep your mileage log and ask whether the lender counts that part. For the home deduction itself, see home office: simplified or actual.

Other Schedule C expenses are not on that list. The Selling Guide separately tells the lender to adjust cash flow for a nonrecurring loss, such as an extraordinary one-time expense (Selling Guide B3-3.6-01).

What does a lender subtract from Schedule C income?

A lender deducts income that will not recur and any meals and entertainment exclusion (Selling Guide B3-3.6-03).

Non-recurring income. Schedule C can include income that did not come from the business's profits. Line 6 collects business income not reported elsewhere, such as recovered bad debts, scrap sales and business prizes and awards (instructions). A one-time item there is the kind a lender may remove.

Meals and entertainment exclusion. Line 24b shows only the deductible part of business meals, in most cases 50% of what you spent (instructions). The Selling Guide topic tells the lender to deduct any such exclusion but gives no calculation. Ask which Schedule C figure the lender's worksheet uses.

What do I give a lender if I have no pay stubs?

A self-employed borrower proves income with filed federal tax returns, not pay stubs. Fannie Mae lets the lender use signed returns with all applicable schedules attached, or IRS transcripts of them (Selling Guide B3-3.5-01). Transcripts stand in only when they carry enough detail to support the income, and the lender may need fewer documents if Fannie Mae's automated validation confirms your Schedule C income (Selling Guide B3-3.1-02).

If you plan to use business money for the down payment, closing costs or reserves, the lender must check the withdrawal will not hurt the business and may ask for several months of business statements or a current balance sheet (Selling Guide B3-3.5-01).

How many years of returns does a lender need?

Fannie Mae generally asks the lender to document two years of earnings, from your signed returns or IRS transcripts (Selling Guide B3-3.5-01).

With less history, the lender may still count your income if your most recent signed returns show a full 12 months of self-employment income from the current business. The file must also document earlier income at the same or a greater level, in a field with the same products or services or a job with similar responsibilities, and the lender must weigh your experience and the business's debt.

A lender may accept one year of returns instead of two when the business has existed for five years and you have held an ownership share of 25% or more for that whole period.

"Most recent year" means the last return scheduled to have been filed with the IRS, and the loan file must always include the last return you have filed. If you apply early in the year, the newest return may not be due or filed yet. What the lender needs then turns on when you apply and when the loan funds (the disbursement date) (Selling Guide B1-1-03).

The dates move if the IRS moves a filing date.

What if my income fell compared with last year?

A falling year is not settled by a formula, but it draws a closer look. Fannie Mae tells the lender to focus on earnings trends and sources of income, confirm that each source is stable and likely to continue, and leave out income that does not appear stable (Selling Guide B3-3.6-01). When it analyzes business income, the lender measures year-to-year trends in gross income, expenses and taxable income (Selling Guide B3-3.5-01).

Neither topic sets a formula for which year's figure a lender uses. The lender may measure trends with Fannie Mae's Comparative Income Analysis (Form 1088), its Income Calculator or another method that fairly shows the business's viability (Selling Guide B3-3.5-01), so ask which one your lender runs. Have a plain explanation ready, such as a lost client, a one-time cost or a seasonal gap, and a current-year statement that shows where income stands, if the facts support it. For an owner of 25% or more of an S corporation or partnership, Fannie Mae states an explicit earnings-trend test; see the S corporation and partnership section.

Does a mortgage lender want a profit and loss statement?

A mortgage lender does not need a year-to-date profit and loss statement for most businesses, but may require one when the application is dated more than 120 days after the end of the business's tax year and it needs the statement to judge whether income is stable or continuing (Selling Guide B3-3.7-04). For a calendar-year business, that is about the end of April.

The statement may be audited or unaudited, and a typical one looks like Schedule C. The topic does not call for a CPA signature, and whether a lender accepts a statement you prepared is its decision; proving self-employed income to a lender covers who can prepare one.

Show depreciation, depletion, home use and one-time items on their own lines so the lender can apply the same adjustments it used on your returns, and use Schedule C categories so statement and return line up (chart of accounts for Schedule C).

Why does the lender pull IRS transcripts, and what must match?

The lender uses transcripts to check the return you handed over against what the IRS holds. The IRS provides tax records to a lender only with your consent, through its Income Verification Express Service: you authorize the request in your IRS account, or through the lender with Form 4506-C.

Fannie Mae requires a signed Form 4506-C from each borrower whose income is used, with exceptions such as income its automated validation confirms. One request covers one return form number, so a personal return and a business return need separate forms (Selling Guide B3-3.1-02).

Your copies of the return, your profit and loss statement and the transcript should be consistent with one another. A return transcript shows most line items as filed and does not reflect later changes, while an account transcript shows later adjustments (form instructions). If a transcript differs from what you gave the lender, the lender keeps the explanation or documentation of the discrepancy in the file.

You can view your own transcripts in your IRS online account to see what the lender will see. For the request itself, see proving self-employed income to a lender.

Should I amend my return or change my books to show more income?

Amend only to fix genuine errors, never to inflate income for a loan, and do not change books to fit a loan. Keep them so a statement can be reconciled to the return, with any differences explained.

A Schedule C expense must be ordinary and necessary. A deduction that was allowed and is supported is not an error, and removing one only to raise reported profit would also raise the tax on that profit. Skipping depreciation does not erase it either: the IRS reduces an asset's basis by the depreciation allowed or allowable, whichever is greater (Publication 946). If your lender follows Fannie Mae's method, it adds back depreciation and the home deduction, so those lines may cost less qualifying income than they appear to.

If the return really is wrong, such as personal costs deducted, income left off or a missed expense, fix it on its own merits (amending for business expense mistakes, amending for income left off past returns), and keep one set of records that supports the return (record keeping for the self-employed). A lender works from the returns you filed, so income that never reached a return is not in the documents it relies on. Income left off generally should be corrected whether or not a loan is pending, with tax plus interest and possibly a penalty. If the original due date has not passed, a corrected return filed and paid by then replaces the original and avoids penalties and interest (IRS Topic 308). Talk to a professional before you amend, not after the application.

Ask the lender whether it wants the amended return and an account transcript: a return transcript shows the return as filed, not later changes. An amendment also takes time. The IRS asks you to allow 8 to 12 weeks for a Form 1040-X, and some take up to 16 weeks (IRS FAQ). A closing date may not wait.

How equipment is deducted on the next return is a tax decision made on tax grounds with your preparer. It changes taxable profit and so your quarterly estimated tax.

How does a lender read an S corporation or partnership instead of Schedule C?

A lender reads your Schedule K-1 and the business return, then tests whether the money was available to you. An S corporation owner may also be paid wages or dividends, separate from the K-1 share (Selling Guide B3-3.7-02). A single-member LLC that the IRS disregards reports on its owner's return, and an individual owner may use Schedule C (Publication 334), so the Schedule C sections above generally apply then. The rows below describe businesses that file Form 1065 or Form 1120-S.

Example

These examples are illustrative and use US dollars. A lender's final figure can differ.

If the lender adds back depreciation and home use

A freelancer's Schedule C shows US$48,000 of net profit after US$9,000 of depreciation and US$3,000 for business use of home. If the lender adds back both under Fannie Mae's rule, the figure becomes US$48,000 + US$9,000 + US$3,000 = US$60,000 before other adjustments. A one-time item or the meals exclusion would then come off.

Income fell

A consultant's Schedule C profit was US$70,000 two years before the application and US$50,000 in the most recent year. The lender reviews the drop in gross income, expenses and profit, may ask for a year-to-date statement and an explanation, and decides which figure is stable. The two Selling Guide topics cited here do not say which figure it uses, so ask which method it runs and what it needs to see.

Under two years of self-employment

A driver forms an LLC taxed as a sole proprietor and starts in July of Year 1. The Year 1 return shows six months and US$20,000 of profit. The Year 2 return shows twelve months and US$50,000. That is 18 months of self-employment, under two years. Once the Year 2 return is filed, the most recent return shows a full 12 months. The lender may then consider the income if the file also documents earlier income at the same or a greater level in the same line of work, such as US$55,000 a year as an employed driver before the LLC. It also weighs any debt the business has taken on.

Different for you?

• A pre-approval came back too low and a closing date is set: which deductions your lender adds back, what a year-to-date statement should show and how the next return is planned depend on your return and the lender's method. Get bookkeeping help for a statement that matches your return and individual tax help before you change the return or the books.
• Your books are behind or do not match the return: a statement that disagrees with the return or the deposits may draw questions. See catching up on overdue books and books to the business tax return, and get bookkeeping help.
• A return is unfiled or years are missing: a lender needs the returns or transcripts for the years it relies on. See Schedule C expenses for unfiled years and get individual tax help.
• Your income comes from an S corporation or partnership: see how S corporations are taxed and how partnerships are taxed, and get corporate tax help.
• Your income is rent, or you need a business loan, not a mortgage: see a rental profit and loss statement for a lender, financial statements for a bank loan and SBA loan statements.