How does a lender determine my income if I am self employed?

*Dream America is not a lender, so the following is meant for illustrative purposes (please consult with a CPA, licensed lending professional, or financial professional in regards to any tax, lending, or investment advice).

For those who are self employed, a lender will likely use their past two years tax returns in order to determine qualified income. So what is qualified income? Simply put, qualified income is the net profit (or loss) from a tax return plus or minus any items that are allowed to be added per mortgage guidelines. An underwriter will take the net profit (or loss) from a tax return and add on or subtract allowable items by using schedule C from the return. Examples of items that can be added back in whole or in part are depletion, depreciation, and a cent per mile rate for business miles.

Okay, great. But, how do I tell???

Let's use an example. Suzy Jones comes to you and in your discussion says, " I earn around $69,000 a year and am self-employed." You respond, "That's excellent. Sounds like a solid business. I'd estimate your income to be around $5750 a month. Since you are self employed, a lender will look at prior tax returns in order to determine qualified income and may even require your current P&L." She then responds, "Oh, I am a first time home buyer and not really sure what qualified income is. I do have my tax return info. with me. Any suggestions on how to tell?

3 great ways to estimate what qualified income may be:

1) Take a look at their 1040 U.S Individual Tax Return. Refer to the following sample Tax return for Suzy.

Two things to look at: Line 1- Wages, salaries, tips, etc. For those who are fully self employed this line will be blank. For those who have self-employment and earn wages, note this line will have income which can also be added to line 8 (other income from schedule 1).  For those who are fully self-employed line 9, total income, is a great indicator of what their qualified income may be. 

Remember, Suzy Jones says she earns $69,000 a year. You will find out below why she is not necessarily being untruthful in a little bit. But, in the sample 1040 above, you will see that her other income is $15,988. This number is the baseline number that a lender will use to determine qualified income.If you see it way below $48,000.00, they most likely will not qualify for Dream America.  Suzy's other income (line 8) of $15,988 is no doubt not going to qualify her for Dream America, and most likely a mortgage any time soon either.

 2) Another great way to get a ballpark would be to take a glance at their form 8879. (Example below) This form is the e-file authorization for the IRS. Many will think it is their "return" and only have that document. It is part of the return, but not the entire return that will be required by both Dream America (and any mortgage lender), but it does have some key info on it that is an indication of what their qualified income is. Look at line 1. Suzy's AGI from line 1 is

$14,858. And line 4. Suzy's refund is $5423. Congratulations to Suzy for having a nice refund coming back to her. However, her Adjusted Gross income of $14,858 makes it extremely unlikely that regardless of any items that can be added back into that income will be enough to have her qualified income of $48,000 annual to qualify for Dream America. And, likewise, with that baseline, she is unlikely to be a homeowner anytime soon.

3) Another great way to determine qualified income if you have self employment is to  use the Schedule C: Profit or Loss from Business (Example below). For those who are solely self employed, line 31 from their schedule C is a key number. That is the net profit or loss. It is not the end all/ be all because there are items that can be added back in (mileage, depreciation) etc. to determine qualified income. But usually, the amounts that can be added back in are not overly significant. So it is an excellent indicator.

Remember Suzy Jones told us at the beginning that she earns around $69,000 a year. In looking at line 1, Suzy does have $69,208 in gross receipts or sales. Solid gross receipts. But Suzy's expenses are heavy! Her total expenses are $53,220. The key number here is line 31 (net profit or loss). This number is the baseline number to use for qualified income. Please note, it is also the same number as line 8 on the 1040 return (example 1 above). Line 31 for Suzy is

$15,988.00. Suzy believes that her income is $5750 a month, but for housing purposes her income is more like $1333.00 a month. A lender would use that qualified income as a baseline in determining qualified income. Dream America uses those exact same calculations since we are a program designed for those seeking homeownership. Though there are items that can be added/subtracted back into line 31 to determine qualifying income, it is most likely that they are significant enough to equate to $48,000 annual or above.

The best advice anyone could give Suzy would be to consult with her accountant to see where her income needs to be in order to qualify for a mortgage.