UNDERWRITING THE SELF-EMPLOYED BORROWER

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1 UNDERWRITING THE SELF-EMPLOYED BORROWER 2010

2 UNDERWRITING THE SELF-EMPLOYED BORROWER 2010

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4 TA B L E O F C O N T E N T S Introduction i Automated Underwriting & the Self-Employed Borrower 1 Basic Business Structures Comparison 5 Tax Returns Form U.S. INDIVIDUAL INCOME TAX RETURN Form 1040 Schedule A - ITEMIZED DEDUCTIONS Form EMPLOYEE BUSINESS EXPENSES Form 1040 Schedule B - INTEREST AND ORDINARY DIVIDENDS Form 1040 Schedule C - PROFIT OR LOSS FROM BUSINESS Form 1040 Schedule C-EZ - NET PROFIT FROM BUSINESS Form 1040 Schedule D - CAPITAL GAINS AND LOSSES Form 1040 Schedule E - SUPPLEMENTAL INCOME AND LOSS Form 1040 Schedule F - PROFIT OR LOSS FROM FARMING Form 1065 Schedule K-1 - PARTNER S SHARE OF INCOME, DEDUCTIONS, CREDITS, ETC Form U.S. RETURN OF PARTNERSHIP INCOME Form 1065 Schedule L - BALANCE SHEETS PER BOOKS Form 1120S Schedule K-1 - SHAREHOLDER S SHARE OF INCOME, DEDUCTIONS, CREDITS, ETC Form 1120S - U.S. INCOME TAX RETURN FOR AN S CORPORATION Form 1120S Schedule L - BALANCE SHEETS PER BOOKS Form U.S. CORPORATION INCOME TAX RETURN Form 1120 Schedule E - COMPENSATION OF OFFICERS Form 1120 Schedule L - BALANCE SHEETS PER BOOKS Form DEPRECIATION AND AMORTIZATION 84

5 TA B L E O F C O N T E N T S Case Study Sole Proprietor 87 Anthony and Mary Sole-Proprietor Form U.S. INDIVIDUAL INCOME TAX RETURN Form 1040 Schedule A - ITEMIZED DEDUCTIONS Form 1040 Schedule B - INTEREST AND ORDINARY DIVIDENDS Form 1040 Schedule C - PROFIT OR LOSS FROM BUSINESS Form 1040 Schedule D - CAPITAL GAINS AND LOSSES Form 1040 Schedule E - SUPPLEMENTAL INCOME AND LOSS Form EXPENSES FOR BUSINESS USE OF YOUR HOME Form DEPRECIATION AND AMORTIZATION Form U.S. INDIVIDUAL INCOME TAX RETURN Form 1040 Schedule A - ITEMIZED DEDUCTIONS Form 1040 Schedule B - INTEREST AND ORDINARY DIVIDENDS Form 1040 Schedule C - PROFIT OR LOSS FROM BUSINESS Form 1040 Schedule D - CAPITAL GAINS AND LOSSES Form 1040 Schedule E - SUPPLEMENTAL INCOME AND LOSSES Form EXPENSES FOR BUSINESS USE OF YOUR HOME Form DEPRECIATION AND AMORTIZATION 112 Income Analysis 114

6 TA B L E O F C O N T E N T S Case Study S Corporation 117 Ads-R-Us/Mark and Mary Applicant W-2 - Mary Applicant W-2 - Mark Applicant Form U.S. INDIVIDUAL INCOME TAX RETURN Form 1040 Schedule A - ITEMIZED DEDUCTIONS Form 1040 Schedule B - INTEREST AND ORDINARY DIVIDENDS Form 1040 Schedule C - PROFIT OR LOSS FROM BUSINESS Form 1040 Schedule D - CAPITAL GAINS AND LOSSES Form 1040 Schedule E - SUPPLEMENTAL INCOME AND LOSS Form EXPENSES FOR BUSINESS USE OF YOUR HOME Form DEPRECIATION AND AMORTIZATION Form 1120S Schedule K-1 - SHAREHOLDER S SHARE OF INCOME, DEDUCTIONS, CREDITS, ETC Form 1120S - U.S. INCOME TAX RETURN FOR AN S CORPORATION Form 1120S Schedule D - CAPITAL GAINS AND LOSSES AND BUILT-IN GAINS Form DEPRECIATION AND AMORTIZATION W-2 - Mary Applicant W-2 - Mark Applicant Form U.S. INDIVIDUAL INCOME TAX RETURN Form 1040 Schedule A - ITEMIZED DEDUCTIONS Form 1040 Schedule B - INTEREST AND ORDINARY DIVIDENDS Form 1040 Schedule C - PROFIT OR LOSS FROM BUSINESS 149

7 TA B L E O F C O N T E N T S Case Study S Corporation (continued) 2008 Form 1040 Schedule D - CAPITAL GAINS AND LOSSES Form 1040 Schedule E - SUPPLEMENTAL INCOME AND LOSS Form EXPENSES FOR BUSINESS USE OF YOUR HOME Form DEPRECIATION AND AMORTIZATION Form 1120S Schedule K-1 - SHAREHOLDER S SHARE OF INCOME, CREDITS, DEDUCTIONS, ETC Form 1120S - U.S. INCOME TAX RETURN FOR AN S CORPORATION Form DEPRECIATION AND AMORTIZATION 164 Income Analysis 167 Case Study Corporate 171 Acme Computer Service, Inc./Joe and Jane Borrower W-2 - Jane Borrower W-2 - Joe Borrower Form U.S. INDIVIDUAL INCOME TAX RETURN Form 1040 Schedule A - ITEMIZED DEDUCTIONS Form 1040 Schedule B - INTEREST AND ORDINARY DIVIDENDS Form 1040 Schedule E - SUPPLEMENTAL INCOME AND LOSS Form U.S. CORPORATION INCOME TAX RETURN Form DEPRECIATION AND AMORTIZATION Form OTHER DEDUCTIONS STATEMENT W-2 - Jane Borrower 189

8 TA B L E O F C O N T E N T S Case Study Corporate (continued) 2008 W-2 - Joe Borrower Form U.S. INDIVIDUAL INCOME TAX RETURN Form 1040 Schedule A - ITEMIZED DEDUCTIONS Form 1040 Schedule B - INTEREST AND ORDINARY DIVIDENDS Form 1040 Schedule E - SUPPLEMENTAL INCOME AND LOSS Form U.S. CORPORATION INCOME TAX RETURN Form DEPRECIATION AND AMORTIZATION Form OTHER DEDUCTIONS STATEMENT 202 Income Analysis 203 Income Analysis Forms 207 Red Flags 243 Glossary 247 Appendix 255

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10 I N T R O D U C T I O N Underwriting loans for the self-employed borrower is one of the most complex and challenging tasks in underwriting. Each case is unique, requiring a special set of skills to analyze this type of borrower. The income of self-employed borrowers must be analyzed differently due to the nature of self-employment. The growth of the business is crucial. The viability, and therefore stability, of the business field is critical to the ability of the borrower to meet ongoing obligations. The length of time self-employed and overall experience in the field must be considered. Comparison of financial documents and tax returns must be completed. You will learn to review federal tax returns to determine qualifying income for the selfemployed borrower. You will receive valuable analytical tools that will make your future evaluation of selfemployed borrowers much easier. A helpful review of red flag areas and a glossary of commonly used terms are also included. Underwriting a mortgage loan requires a sensitive analysis of many elements necessary to finance a home. These elements are commonly referred to as the four "Cs" of underwriting: credit, collateral, capacity and character. The underwriter will balance these key factors to establish that the terms of the loan are related to the probability of the borrower s repayment and to the value and marketability of the mortgaged property. This casebook addresses only the borrower s capacity to manage debt. i

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12 Affect of DU/LP on Underwriting SEB

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14 A U T O M AT E D U N D E RW R I T I N G & T H E S E L F - E M P L O Y E D B O R R O W E R AUTOMATED UW In view of the important role played by automated underwriting in the origination of conventional loans in today s marketplace, PMI feels that it is prudent to discuss its impact on the underwriting process in our Self-Employed Borrower workbook. N O T E S Both GSEs, Fannie Mae and Freddie Mac, provide guidance on how to assess the loan applications of self-employed borrowers using their respective automated underwriting systems. As explained in Fannie Mae s and Freddie Mac s Guide to Automated Underwriting manuals, there are some basic rules for underwriting selfemployed borrowers. Both Fannie Mae and Freddie Mac consider a borrower to be self-employed if the borrower has a 25% or greater ownership interest in a business. The business may be a sole proprietorship, a partnership (general or limited), an S corporation or a corporation. When processing self-employed borrower loans, either through agencies or automated underwriting systems, the underwriter should pay close attention to the documentation requirements listed on the underwriting findings report. Depending on the overall borrower profile, automated underwriting system results may differ from loan to loan. For example, the underwriting findings report may only condition the loan for 1 year s personal federal tax return. It is therefore important for the underwriter or processor to pay close attention to the level of documentation required by the automated underwriting system findings report, i.e., those documents that must be included in the loan file. 3

15 AUTOMATED UW N O T E S 4

16 Basic Business Structures

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18 B A S I C B U S I N E S S S T R U C T U R E S C O M PA R I S O N FEATURE COMPARISON The structure of the business will determine the documents required to evaluate the borrower s income from self-employment and overall financial condition. BASIC.BUSINESS Type of Business Degree of Liability Control Over Management Tax Implications Sole Proprietorship Unlimited personal liability Owner has total control Taxed at individual rates General Partnership Unlimited liability for any Majority rule, Taxed at individual and all partnership debts unless otherwise rates on share of and other liabilities agreed net income Limited Partnership Liability limited to General partners have Taxed at individual rates investment operational control on share of net income Corporation Liability limited to Officers elected by Double taxation investment Board of Directors treatment: taxed (often the same in at corporate rate; closely held corporations) distributed earnings (dividends to shareholders) also taxed at individual rates S Corporations Liability limited to Officers elected by Taxed at individual investment Board of Directors rates on share of (often the same in S net income corporations) Limited Liability Liability limited to Depends on provisions Taxed at individual Company (LLC) investment of LLC agreement. rates on share of Generally, LLC members net income have direct control. 7

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20 Tax Returns

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22 TA X. R E T U R N S TAX REPORTING FORMS Analysis of the borrower s U.S. Individual Income Tax Return (IRS Form 1040) will provide information about the sources of income available for debt repayment. Further detail of each source of income is provided on supporting schedules and, when appropriate, on separate business tax returns. Complete returns, including all schedules and business tax returns, should be provided so that the underwriter can evaluate the borrower s cash flow and financial condition. Following is a summary of the most important tax forms for the analysis of a self-employed borrower. TAX. RETURNS PERSONAL INCOME STATEMENTS Tax Forms and Schedules Form 1040 Schedule A (1040) Schedule B (1040) Schedule C (1040) or Schedule C-EZ (1040) Schedule D (1040) Schedule E (1040) Schedule F (1040) Form 4562 Description U.S. Individual Income Tax Return - Lists all the income of the borrower; if the borrower is a sole proprietorship, a partnership or an S corporation, the business income is also reported on attached schedules. Itemized Deductions - Lists deductions that may be subtracted from the borrower s adjusted gross income before calculating the tax liability, including unreimbursed employee expenses. Interest and Dividend Income - Lists the sources and amounts of investment income, including tax-exempt interest, non-taxable dividend distributions, and dividend income earned on stocks sold during the year (capital gains). Profit or Loss From Business - A separate schedule that details the profit or loss from the sole proprietorship. This form is in an income statement format. Net Profit from Business - A simplified statement of net profit from a sole proprietorship. May only be used if the business reported a profit during the tax year and other limiting conditions are met. Capital Gains and Losses - A separate schedule that details gains or losses from investments, i.e., stocks and bonds. (Only a part of cash-flow analysis if it is of a recurring nature.) Supplemental Income and Loss - A separate schedule that details supplemental income from rental properties, partnerships, S corporations, estates, trusts, etc. Profit or Loss From Farming - A separate schedule that details the profit or loss from farming. Depreciation and Amortization - A separate form that breaks out amortization and depreciation. While an individual partner s income is summarized on Schedule E and reported on the 1040, the partnership or S corporation must file business returns. 11

23 TA X. R E T U R N S PARTNERSHIP STATEMENTS Tax Forms and Schedules Description TAX. RETURNS Form 1065 Schedule L (1065) Schedule K-1 (1065) U.S. Partnership Return of Income - Reports the earnings of the Partnership in income statement format. Balance Sheets - Summary of assets and liabilities as of the beginning and end of the tax year. Partner s Share of Income, Credits, Deductions, etc. - Lists details of each partner s capital account, the individual partner s percentage of ownership, and outlines the profit and loss of a partner. Form 4562 Depreciation and Amortization - This is a separate form that details the amortization and depreciation expense of the partnership. CORPORATE STATEMENTS Tax Forms and Schedules Form 1120 Schedule E (1120) Schedule L (1120) Form 4562 Description U.S. Corporation Income Tax Return - Reports the earnings of the corporation in income statement form. Compensation of Officers - A list of corporate officers that shows each officer s percentage of stock ownership, percentage of time devoted to the business, and amount of annual compensation. Balance Sheets - A summary of assets and liabilities as of the beginning and end of the tax year. Depreciation and Amortization - This is a separate form that details the amortization and depreciation expense of the corporation. S CORPORATION STATEMENTS Tax Forms and Schedules Form 1120S Schedule L (1120S) Schedule K-1 (1120S) Form 4562 Description U.S. Income Tax Return for an S corporation - Reports the earnings of the S corporation in income statement form. Balance Sheets - A summary of assets and liabilities as of the beginning and end of the tax year. Shareholder s Share of Income, Credits, Deductions, etc. - Lists the shareholder s share of income, credits, deductions, etc., and reflects assets and liabilities of the shareholder. Depreciation and Amortization - This is a separate form that details the amortization and depreciation expense of the S corporation. Corporations, just like individuals, pay income taxes. Any corporate earnings distributed to stockholders as dividends or salaries will appear on the individual s 1040s. All corporate income is subject to corporate income tax first. 12

24 TA X. R E T U R N S TAX RETURN FORMS AND SUPPORTING SCHEDULES TAX. RETURNS S K F K-1 S CORPORATION E A&B C D PARTNERSHIP/LLC 1040 SOLE PROPRIETOR/LLC CORPORATION INDIVIDUAL TAXPAYER 13

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26 TA X. R E T U R N S FORM 1040 (PAGE 1) - U.S. INDIVIDUAL INCOME TAX RETURN N O T E S From an underwriting point of view, this form is very important because it summarizes taxable income, which is shown in greater detail on the supporting schedules. The personal information on the 1040 should be consistent with the information provided on the loan application. Line 7 TAX. RETURNS Wages, Salaries, Tips, Etc. An entry here does not require a supporting schedule. However, the taxpayer must attach a copy of the W-2 statement issued by his or her employer. The underwriter should consider several points if this line reflects income. If the applicant operates as a sole proprietorship, he cannot pay himself a salary. However, if he is the owner of a corporation, he could be an employee and pay himself a salary. One of the partners could be an employee of the partnership and therefore receive a compensation in the form of Salary or Guaranteed Payments. This would be reflected on the borrower s Schedule K-1 (1065), issued by the partnership, in addition to his or her share in the profit or loss. Lines 8a and 8b Taxable and Tax-Exempt Interest Income An underwriter can usually document interest income by reviewing copies of Form 1099-INT from the financial institution that paid the interest. The individual sources can be identified on Schedule B. If the loan applicant has nontaxable income (Line 8b), the underwriter must identify and document this source of income. Interest income may be used to qualify the borrower if it is continuous (minimum of a 2-year history) and the assets will not be liquidated for the down payment or closing costs. Additionally, interest received from an outstanding note is reported here. The income may be used to qualify if it has been received for at least one year and the income will continue to be received for at least three years after loan closing. Lines 9a and 9b Ordinary and Qualified Dividends As with interest income, dividends (generally from stocks and mutual funds) may be added to qualifying income if continuous and the assets will not be liquidated for the down payment or closing costs. If over $1,500, this income will be identified on Schedule B. 15

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28 TA X. R E T U R N S Line 10 N O T E S Taxable Refunds, Credits, or Offsets of State and Local Income Taxes Tax refunds must be declared as income for tax purposes. Tax refunds do not meet the criteria of stable income and thus are not added to qualifying income. Also, tax refunds reflect an overpayment of taxes on the prior year s income, which has been accounted for in the previous year s gross income computation. Line 11 TAX. RETURNS Alimony Received Alimony may be included in determining income only if the payment is received as a result of a divorce decree or signed written agreement that is a legal obligation. The periodic payments must be verified as stable for at least one year. The alimony received must continue for at least three more years after loan closing. Line 12 Business Income or (Loss) Business income from a sole proprietorship will be summarized here and detailed on Schedule C or C-EZ. The amount reported as depreciation expense on Schedule C may be added to the reported business income and considered for qualifying purposes. To determine this amount you must refer to Form 4562, which details depreciation costs. While depreciation and depletion are noncash expenses, PMI s philosophy is that these represent a reserve for future replacement of assets of the business. Using these reserves as disposable income could impact cash flow. Review this carefully (i.e., can the company withstand additional liability or cash expenditures?). Lines 13 and 14 Capital Gain or (Loss) and Other Gains or (Losses) Long- and short-term capital gains and losses and other gains and losses generally do not represent stable and recurring income and should not be considered in determining qualifying income. However, if the borrower has a constant turnover of assets that produce regular gains and losses, they may be considered (e.g., a person who routinely buys old houses, remodels them, and sells them for a profit). Capital gains and losses are detailed on Schedule D. Gains and losses from the sale of business property and ordinary gains and losses are reported on Form If income from capital gains is considered, an average net of the borrower s capital gains and losses may be added to qualifying income, if there is a verified 2-year history of such gains. Keep in mind that future income may be reduced as a result of selling income-producing assets. In addition, if the gain has been reinvested, it may not be in a form that can be easily liquidated. Schedule D should be carefully analyzed to ensure that the amount shown here reflects the true amount as page 1 of the 1040 will only show a maximum allowable loss of $3000. The actual amount should be used when qualifying the borrower. 17

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30 TA X. R E T U R N S Lines 15a, 15b, 16a and 16b N O T E S IRA Distributions, Pensions and Annuities, Including Rollovers Amounts from these sections can be added to qualifying income if they are verified, stable and continuous in nature. Rollovers are nontaxable transfers of investments from one retirement investment to another. Rollovers are to be reported on the tax form, but do not represent distributions to the borrower. One-time, lump-sum distributions and rollovers should not be considered as income for loan qualification. TAX. RETURNS Line 17 Rental Real Estate, Royalties, Partnerships, S Corporations, Trusts, Etc. Income or losses from rental of real estate, royalties, a partnership or S corporation, and estates and trusts will be summarized here and detailed on Schedule E. This income may be added to qualifying income if it is verified as stable and continuous in nature. Amortization, depreciation, or depletion expense may be added to net income. In order to determine the amount of amortization or depreciation from a partnership or S corporation, refer to the following: Partnerships: Form 1065 Schedule K-1 and Form 4562 S corporations: Form 1120S Schedule K-1 and Form 4562 Line 18 Farm Income or (Loss) Farm income may be added to qualifying income in addition to any amortization or depreciation that is reported on Schedule F. This income should be considered stable, regular, and recurring in nature. Line 19 Unemployment Compensation This income is considered temporary and is generally not considered by the underwriter when determining qualifying income. An exception may be warranted where the borrower is employed in a seasonal industry or is in an occupation that is typically jobbed out by a union or other organization and unemployment benefits are verified as a traditional and continuing source of income. A minimum 2-year history is required. Lines 20a and 20b Social Security Benefits Certain portions of income received as Social Security benefits are not taxable. The borrower can be given credit for all of this income if the benefits will be ongoing. 19

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32 TA X. R E T U R N S Line 21 N O T E S Other Income Income in this category is usually extraordinary and nonrecurring, and should not be considered for qualifying purposes. Examples include lottery winnings, awards, and relocation bonuses. However, if income reported in this category can be verified, and is determined to be stable and continuous, it may be considered when determining qualifying income. Examples of such income would be the earnings of a person who provides contract services (consultant, public speaking, etc.). This income is reported on IRS Form TAX. RETURNS Adjusted Gross Income Adjustments to income are certain expenses which can directly reduce total income. It is important to analyze these expenses to determine if any should be considered in qualifying the borrower. Line 23 Educator Expenses A taxpayer may be able to take this deduction if he/she was an eligible educator in the year the expenses were claimed. Line 24 Certain Business Expenses of Reservists, Performing Artists, and Fee-Basis Government Officials Taxpayers with the following expenses may deduct them: Certain business expenses of National Guard and reserve members who traveled more than 100 miles from home to perform services as a National Guard or reserve member. Performing arts-related expenses as a qualified performing artist. Business expenses of fee-basis state or local government officials. These expenses will be reported on Form 2106 or 2106-EZ. If there is amount on Line 24, it should not be included as income. Line 25 Health Savings Account Deduction A taxpayer may be able to take this deduction if contributions (other than employer contributions) were made to his/her health savings account in the year the deduction is claimed. The amount should not be included as income. 21

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34 TA X. R E T U R N S N O T E S Line 26 Moving Expenses If the taxpayer moved in connection with his/her job or business or started a new job, he/she may have taken this deduction. The new workplace must be at least 50 miles further from the old home than the old home was from the old workplace. If there was no former workplace, the new workplace must be at least 50 miles from the old home. See Form TAX. RETURNS Line 27 One-Half of Self-Employment Tax Half of the tax paid on income earned from self-employment can be deducted from the individual s taxable income. Schedule SE must be completed to determine the amount of the deduction. This should not be subtracted from the borrower s qualifying income. Lines 28 and 32 Self-Employed SEP, SIMPLE, IRA Deduction Discretionary contributions made to IRAs (Individual Retirement Account), Keogh, Self-Employed SEP, and SIMPLE plans should be included in qualifying income. Line 29 Self-Employed Health Insurance Deduction This is a deduction reflecting health insurance premiums paid by a self-employed borrower. This should not be subtracted from the borrower s qualifying income. Line 30 Penalty on Early Withdrawal of Savings If the borrower withdrew funds from a term account prior to maturity, a penalty amount may be entered on Line 30. This should not be subtracted from the borrower s qualifying income. Line 31a Alimony Paid Alimony is considered to be a long-term obligation unless otherwise indicated by the divorce settlement. The alimony deducted here should not be subtracted from cash flow, but should be added to the borrower s long-term debt when calculating the overall debt-to-income ratio. 23

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36 TA X. R E T U R N S N O T E S Line 33 Student Loan Interest Deduction A portion of the interest paid on a student loan may be deducted from adjusted gross income. Because the full monthly payment amount will be included in long-term debt for qualification, the amount on this line should not be subtracted from the borrower s qualifying income. TAX. RETURNS Line 34 Tuition and Fees Deduction If the taxpayer paid qualified tuition and fees for themselves, their spouse, or their dependent(s), they may be able to take this deduction. Line 35 Domestic Production Activities Deduction This deduction is applicable to domestic businesses that manufacture, grow, produce or extract qualifying property. The borrower may be able to deduct up to 3% of the qualified production activities income from certain business activities. 25

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38 TA X. R E T U R N S N O T E S FORM 1040 (PAGE 2) - U.S. INDIVIDUAL INCOME TAX RETURN No line items listed on this page should be added to the borrower s cash flow. Line 40a Itemized Deductions (from Schedule A) or Your Standard Deduction TAX. RETURNS Review this line to determine whether the borrower itemized deductions or took the standard deduction (as noted in the left margin of page 2 of the 1040). If the borrower did not take the standard deduction, Schedule A must be attached. Line 56 Self-Employment Tax The amount on this line is the taxes a self-employed business person, business person, excluding church employee income, earning $400 or more is required to pay. The taxpayer must complete Schedule SE to determine the amount of self-employment tax. Signature Line The tax returns you receive should be signed and dated with the date you received them. This certifies there are no amended returns in existence. 27

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40 TA X. R E T U R N S SCHEDULE A (FORM 1040) - ITEMIZED DEDUCTIONS N O T E S A taxpayer may itemize his or her deductions in order to reduce the tax liability. Schedule A must be completed to support the expenses being itemized. This schedule should be reviewed for several line items. If the borrower did not itemize his or her deductions, there is no need for Schedule A. Line 6 Real Estate Taxes TAX. RETURNS If the borrower has indicated that he or she owns real estate (owner-occupied residence), there should be a deduction on this line for real estate taxes paid. Taxes paid on investment property are reported on Schedule E. Lines 10 and 11 Deductible Home Mortgage Interest If the borrower is a current homeowner, a deduction for mortgage interest would be indicated here if interest was paid on a mortgage loan secured by either their primary residence or second home. Line 21 Unreimbursed Employee Expenses These are business expenses that are allowed as a deduction from Adjusted Gross Income when calculating the tax liability. The borrower must file Form 2106 or 2106-EZ (Employee Business Expense) to support the deduction. Form 2106 should be reviewed and qualifying income should be reduced by the actual amount of cash expenditures shown on this form, which may not correspond identically to Line 20 of Schedule A. (Refer to page 27 for further detail of Employee Business Expenses.) 29

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42 TA X. R E T U R N S FORM 2106 (PAGE 1) - EMPLOYEE BUSINESS EXPENSES N O T E S Borrowers who are not self-employed and have expenses related to work (i.e., travel, transportation, car, meal, entertainment, or gift expenses) are allowed to deduct certain costs as an itemized expense. Form 2106 reports reimbursed and unreimbursed business expenses. TAX. RETURNS Step 1 Form 2106 lists the borrower s total expenses. Step 2 Shows the offsetting amounts paid by the borrower s employer (not reported as salary or wages). Step 3 Subtracts the amount paid by the employer and arrives at the net amount a borrower is allowed to claim as an itemized deduction. Only 50% of the unreimbursed meals and entertainment cost may be deducted during the year, but in reality all of the money was spent. To account for this loss in deduction, you must subtract all of the actual expenditures from cash flow. Add Columns 8A and 8B together and subtract the total from income. 31

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44 TA X. R E T U R N S FORM 2106 (PAGE 2) - EMPLOYEE BUSINESS EXPENSES N O T E S Line 13 Business Miles Included on Line 12 The standard mileage rate for the business use of a car includes depreciation. This is a noncash expense and may be added back to cash flow as follows: Multiply the number of business miles listed on Line 13 by the appropriate tax year rate to determine the amount to add back TAX. RETURNS Depreciation Rates by Tax Year: 2007: $ : $ : $0.23 Line 24a Vehicle Rentals If borrower leases a vehicle for business purposes, he or she may write off that amount on this line. This is an actual cash expense and this amount should not be used in qualifying income. Line 28 Auto Depreciation Vehicle depreciation may be claimed as part of the borrower s vehicle expense. This should be added back to cash flow. 33

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46 TA X. R E T U R N S SCHEDULE B (FORM 1040) - INTEREST AND ORDINARY DIVIDENDS N O T E S Schedule B summarizes all interest and dividends earned during the tax year. Sources of the income are listed and can be cross-referenced with the borrower s depository relationships to verify that they are consistent with the loan application. TAX. RETURNS 35

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48 TA X. R E T U R N S SCHEDULE C (FORM 1040) - PROFIT OR LOSS FROM BUSINESS (Sole Proprietorship) N O T E S Schedule C is the Profit or Loss from Business (Sole Proprietorship) for tax purposes. The items of particular interest to the underwriter in determining the borrower s income are as follows: Line F Accounting Method TAX. RETURNS This schedule includes a section that indicates the method of accounting used. Cash basis means that income is recognized when cash is received and expenses are recognized when cash is paid. Accrual basis means that income is recorded when the service is performed or goods are shipped, and expenses are recorded when incurred. If the cash method is used, Schedule C offers a fair approximation of cash flow. Under accrual accounting, actual cash flows may be distorted because cash is not received or paid when transactions are shown in the business books. Instead, amounts will be shown as accounts payable or accounts receivable. The underwriter should be careful when reviewing accrual basis data, because revenue shown could exceed the actual cash position. Part I Income Part I reflects total revenues, less cost of goods sold and items returned, to arrive at gross income. For service companies, there will generally be no deductions from gross receipts or sales. Business expenses will be reported in Part II. Part II Expenses Part II is generally equivalent to the expense section of an income statement (profit or loss); i.e., the itemization of the expenses necessary to operate the business. Amortization and depreciation will be supported by Form 4562 and can be added to qualifying income. 37

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50 TA X. R E T U R N S Line 12 N O T E S Depletion Depletion: The allocation of expense reflecting the decrease of a nonrenewable natural resource. This could be oil, gas, gravel, lumber, or other depletable natural resources. A business that uses up a natural resource in the normal operation of the business is allowed to allocate the total costs of that natural resource as it is extracted over time. This is a noncash expense and may be added back to cash flow. TAX. RETURNS Line 13 Depreciation Depreciation: The decline in value of an asset based on age, physical wear, and economic or functional obsolescence. Real depreciation refers to real estate (residential or commercial property). Chattel depreciation is an asset with a relatively short life span (furniture, cars, and office equipment). Both real and chattel depreciation may be added back to cash flow. While depreciation is a noncash business expense, financial capacity of the business should be evaluated to ascertain that assets can be replaced as needed. Line 24b Deductible Meals and Entertainment Typically, 50% of the borrower s out-of-pocket costs for business-related meals and entertainment are deductible on the tax return. The remaining 50% of costs must be absorbed by the borrower and therefore should be subtracted from the borrower s qualifying income. Note: Borrowers subject to the Department of Transportation (DOT) hours of service limits may deduct 80% of their business meals. Line 27 Other Expenses Amortization expenses and casualty losses will be located in the other expenses area of the Expenses section. Amortization: A deductible expense allowed as a means of recovering the investment in intangible assets of the business. Examples of amortized assets include the initial costs of surveys, attorney fees, and purchase of copyrights or customer lists. These amounts may be added back to qualifying income. 39

51 TA X. R E T U R N S TAX. RETURNS 40

52 TA X. R E T U R N S Line 30 N O T E S Business Use of Home - Form 8829 This is an allowable deduction for business use of the borrower s residence, such as space dedicated to an office or storage of materials and supplies used by the business. This amount may be added back to cash flow. Line 31 Net Profit or (Loss) TAX. RETURNS Net profit or (loss) is equal to the gross income from Part I less total expenses from Part II. If the amount is a profit on Line 31, enter it on Form 1040, Line 12, and Schedule SE, Line 2. Only if there is a (loss) on Line 31, the borrower will be required to complete Line 32. When determining income for qualification, the underwriter will generally consider net profit or (loss) less any adjustments, plus any noncash or nonrecurring expenses, such as amortization, depreciation, depletion, or casualty loss. Line 32 Generally, if the borrower has (a) business loss and (b) amounts in the business for which the borrower is not at risk, the borrower will have to complete Form 6198 to figure out the allowable loss. The At Risk Rules generally limit the amount of loss (including loss on the disposition of assets) the borrower can claim to the amount actually lost in the business. Additional information can be found in the instructions for the Schedule C tax form. 41

53 TA X. R E T U R N S TAX. RETURNS 42

54 TA X. R E T U R N S SCHEDULE C-EZ (FORM 1040) PAGE 1 - NET PROFIT FROM BUSINESS N O T E S This simplified form can be used by sole proprietors if the business: reports income and expense on a cash basis has not reported a net business loss for the tax year has not had an inventory of goods during the year has expenses of $5,000 or less TAX. RETURNS has no employees does not report expenses for use of an office in the home has no prior-year passive activity losses did not report depreciation on Form 4562 is the only business owned as a sole proprietor Line 1 Gross Receipts The total amount actually or constructively received from trade or business operation is entered. This will include cash, property, and services either received during the year or credited to the account of, or set aside for use by, the taxpayer. If the borrower is a statutory employee, such as a full-time life insurance salesman, commissioned driver or full-time outside salesperson, and the income shown on Line 1 is as shown on Form W-2, the box should be checked. If income shown on Line 1 is also reported on Form 1099-MISC and the amount on the Form 1099-MISC is greater than the amount on Line 1, an explanation must be provided. Through review of the business financial statements (profit or loss) or other supporting documentation, the underwriter will ensure that only actual cash or cash equivalents received during the tax year are considered for qualifying income. Line 2 Total Expenses All deductible business expenses actually paid during the year are reported. 43

55 TA X. R E T U R N S TAX. RETURNS 44

56 TA X. R E T U R N S SCHEDULE C-EZ (FORM 1040) PAGE 2 - NET PROFIT FROM BUSINESS N O T E S Line a Deductible Business Meals and Entertainment Typically, 50% of the borrower s out-of-pocket costs for business-related meals and entertainment are deductible on the tax return. The remaining 50% of costs must be absorbed by the borrower and therefore should be subtracted from the borrower s qualifying income. TAX. RETURNS Note: Borrowers subject to the Department of Transportation (DOT) hours of service limits may deduct 80% of their business meals. If the Optional Worksheet for Line 2 is not completed, the underwriter will review the financial statements (profit or loss) and supporting documentation to verify the amount of nondeductible business expense reported during the year. 45

57 TA X. R E T U R N S TAX. RETURNS 46

58 TA X. R E T U R N S SCHEDULE D (FORM 1040) - CAPITAL GAINS AND LOSSES N O T E S Schedule D is designed to detail short-term and long-term gains and losses from the sale of assets such as stocks, bonds, and real estate. Unless the borrower constantly turns over such assets, capital gains and losses are not considered when determining qualifying income. If capital gains are to be considered, develop an average gain figure (net of capital losses for the period) based on a verified 2-year history. This must be the borrower s primary source of income and none of the assets can be used for closing of the transaction. TAX. RETURNS Line 7 and 15 Net Short-term and Long-term Capital Gain or (Loss) Combine the amounts on lines 7 and 15 to determine the net capital gain or loss. 47

59 TA X. R E T U R N S TAX. RETURNS 48

60 TA X. R E T U R N S SCHEDULE D (FORM 1040) PAGE 2 - CAPITAL GAINS AND LOSSES N O T E S Line 16 Contains the combined gain/loss from lines 7 and 15 and reflects the actual gain/loss that should be considered for qualifying purposes. TAX. RETURNS 49

61 TA X. R E T U R N S TAX. RETURNS 50

62 TA X. R E T U R N S SCHEDULE E (FORM 1040) - SUPPLEMENTAL INCOME AND LOSS N O T E S This form is used to report income from rental property, royalties, partnerships, S corporations, estates, trusts, and real estate mortgage investment conduits. Part I Income or Loss From Rental Real Estate and Royalties TAX. RETURNS Lines 3 and 4 Rents and Royalties Received Lines 3 and 4 detail income from rental property and royalties. Royalties can, in some instances, meet the criteria for stable, continuous income. They may be used if there is a history and reasonable expectation of continuance for a minimum of three years. Royalties are generally received from copyrighted material or natural resources. Rental property income may be considered, but the underwriter should consider the cash requirements that affect income of this type. For example, landlords should have sufficient cash for unexpected vacancies. Add Lines 3 and 4 to income. Line 19 Total Expenses Line 19 reflects the total amount paid for the maintenance and upkeep of the property. This also includes mortgage interest and taxes. These expenses are subtracted from income. 51

63 TA X. R E T U R N S TAX. RETURNS 52

64 TA X. R E T U R N S Part II N O T E S Income or Loss From Partnerships and S Corporations Part II lists income from partnerships and S corporations. The underwriter should remember that this income is taxed, whether or not the taxable amount was distributed to the individual partner or shareholder. For this reason, extreme caution should be used in allocating partnership or S corporation income by determining a stable monthly qualifying income amount. The Schedule K-1 should be analyzed to determine the actual amount of income received by the borrower during the tax year. TAX. RETURNS Line 28(i) Section 179 Expense Section 179 property is property that was purchased for the active use by the trade or business. Part or all of the cost of the section 179 property may be expensed in the year in which it was placed in service. The taxpayer s share of the section 179 expense may be added back to income. Line 32 Total Partnership and S Corporation Income or Loss The borrower s share of partnership or S corporation income or loss is reported here. This amount should be considered in determining qualified income. Part III Income or Loss From Estates and Trusts Part III lists estate or trust income that may be used if properly documented by copies of the trust agreements and the trustee s or estate manager s statement confirming the amount, frequency, and duration of payments. A copy of the K-1 from the fiduciary should be supplied by the applicant. The Estate/Trust income should meet the following criteria if it is to be added to qualifying income: 1. The income must continue for at least three years after loan closing. 2. Trust must be irrevocable. 3. A copy of the trust must be provided that establishes the borrower s right to the trust funds. 4. Verification of trust assets should be provided. 5. Two-year history of receipt of trust income should be verified. 53

65 TA X. R E T U R N S TAX. RETURNS 54

66 TA X. R E T U R N S Part IV N O T E S Income or Loss From Real Estate Mortgage Investment Conduits Part IV will report the annual share of income or loss from a residual interest in a real estate mortgage investment conduit (REMIC). If more than one residual REMIC interest is held, each will be reported separately using an attachment to Schedule E. Income for the holder of a regular interest in a REMIC will be reported on Form 1040, Line 8a (taxable interest). TAX. RETURNS 55

67 TA X. R E T U R N S TAX. RETURNS 56

68 TA X. R E T U R N S SCHEDULE F (FORM 1040) - PROFIT OR LOSS FROM FARMING N O T E S Schedule F is the Profit or Loss from Farming. The items of particular interest to the underwriter in determining the borrower s gross income are very similar to Schedule C. Part I Farm Income (Cash Method) When the cash method of accounting is used, Part I reflects gross revenue from farming operations during the tax year. This revenue includes income from sale of products less cost of goods bought for resale, farm cooperative distributions, agricultural program benefits, crop insurance proceeds, and so forth. TAX. RETURNS The underwriter will analyze each source of revenue to determine if it is continuous in nature. All stable recurring income will be considered for qualification. Part II Farm Expenses When the cash or accrual accounting method is used, Part II is used to itemize the expenses incurred in operating the farm. Total expenses should be subtracted from qualifying income. Line 16 Depreciation Depreciation is a noncash expense and can be added to income for qualification. Line 36 Net Farm Profit or (Loss) Net farm profit or (loss) is equal to the gross income from Part I or III less total expenses from Part II. 57

69 TA X. R E T U R N S TAX. RETURNS 58

70 TA X. R E T U R N S Part III N O T E S Farm Income (Accrual Method) When the accrual method of accounting is used, Part III reflects gross revenue received (or receivables) from farming operations. The accrual method will record income when goods are sold, regardless of whether or not the farmer has actually received the money, likewise, expenses are recorded when a liability is incurred, whether or not it is immediately due and payable. If the accrual method is used, the underwriter will review the farm financial statements rather than Schedule F to determine the actual cash flow during the reporting period. TAX. RETURNS 59

71 TA X. R E T U R N S TAX. RETURNS 60

72 TA X. R E T U R N S SCHEDULE K-1 (FORM 1065) - PARTNER S SHARE OF INCOME, DEDUCTIONS, CREDITS, ETC. N O T E S The individual s share of partnership income is reported on Schedule K-1. Because partnership assets are generally used to fund future business operations, discretion should be used if including withdrawals and distributions from the partnership for qualifying purposes. If a 2-year history of distributions is demonstrated through reconciliation of the borrower s capital account, add this amount to the borrower s qualifying income. TAX. RETURNS Part I of the form contains information about the partnership. Part II contains information about the individual partner. Part III addresses the partner s share of income, deductions, credits and other items. Part II Information About the Partner Line G Identifies the borrower s status as a limited or general partner or limited-liability investor. Liability for business debts and other obligations of the partnership are restricted to the amount of their initial investment for a limited partner or limited-liability investor, plus the amount of any subsequent contribution made, or any amount that has been agreed to be paid. A general partner has unlimited liability for the debts and other obligations of the partnership. In the event of default on an obligation, a creditor can seek remedy from assets of the business, personal assets of the general partner, or both. Line J Indicates the partner s percent of profit and loss sharing and ownership of capital. 61

73 TA X. R E T U R N S TAX. RETURNS 62

74 TA X. R E T U R N S Line L N O T E S Provides a reconciliation of the partner s capital account. From this reconciliation, the underwriter will determine if the individual partner contributed capital during the year and if any withdrawals or distributions were made. The cash flow of the individual can be affected by such activities. Note whether the capital account is increasing or decreasing. Beginning Capital Account This is the amount of money that the borrower had in the account at the beginning of the year. TAX. RETURNS Capital Contributed During the Year This is the borrower s monetary contribution made to the partnership during the year. Current Year Increase (Decrease) This amount represents the partner s share of net income as reflected in the partnership s tax return. Withdrawals and Distributions This amount reflects the fair market value of property or cash distributed by the partnership to the partner during the year. Normally, this will be cash only but other items may be included. It is important to determine the nature of the distributions. Withdrawals or distribution of assets are generally considered a return of investment rather than income and will not be taxed. A return on investment should generally not be considered income for qualification. Ending Capital Account This amount represents the balance the borrower has in the account at the end of the year. Should the amount be negative, the borrower may be required to contribute additional capital. 63

75 TA X. R E T U R N S TAX. RETURNS 64

76 TA X. R E T U R N S Part III N O T E S Partner s Share of Current Year Income, Deductions, Credits and Other Items Line 1 Ordinary Business Income (Loss) This is the partner s distributive share of ordinary income or loss from the partnership. Partners are allocated portions of income, loss, deductions, and credits earned by the partnership. Partners pay tax or take deductions on their personal tax returns for these pass-through items. TAX. RETURNS Income from the partnership becomes taxable when distributed to the partners. Line 4 Guaranteed Payments These payments are made to the partner for services rendered or for the use of capital. These payments are made without regard to the partnership s profits and are subject to self-employment tax by the partner. 65

77 TA X. R E T U R N S TAX. RETURNS 66

78 TA X. R E T U R N S FORM U.S. RETURN OF PARTNERSHIP INCOME N O T E S Form 1065 is the required filing for partnerships. This informational form lists the partnership s income, loss, deductions, and credits. The individual partners pay tax on their pass-through share of income. The partnership is required to provide a Schedule K-1 to each partner. Line E TAX. RETURNS Date Business Started Review this information to determine the age of the business. Line 4 Ordinary Income (Loss) From Other Partnerships, Estates, and Trusts Partnerships can be partners in other partnerships or have an interest in an estate or trust. Ordinary income or loss (not including portfolio income or income from rental activity) is reported here. You must analyze each of these entities to determine its viability and whether the income should be included in the partnership s return for qualification. Line 7 Other Income (Loss) Analyze this income to determine the probability of it being regular and recurring. Lines 16a and 17 Depreciation and Depletion Depreciation is a noncash business expense that is allocated over the useful life of an asset. Financial capacity of the business should be evaluated to ascertain that depreciated assets can be replaced as needed. Depletion is also a noncash expense reflecting the decrease of a non-renewable resource. If the depletion of this resource will not adversely impact future business operation, the amount of depletion allowance can be added to cash flow of the partnership. Multiply both amounts by the borrower s ownership percentage as shown on Schedule K-1 (Form 1065). Add the borrower s net share of depreciation and depletion to the borrower s qualifying income. Line 22 Ordinary Business Income (Loss) Ordinary income or loss is divided among the partners. Your borrower s share is shown on Line 1 of Schedule K-1 (Form 1065). 67

79 TA X. R E T U R N S TAX. RETURNS 68

80 TA X. R E T U R N S SCHEDULE L (FORM 1065) - BALANCE SHEETS N O T E S Line 16 Mortgages, Notes, Bonds Payable In Less Than One Year Analysis must be conducted to determine if required repayment of these debts will adversely impact the partnership s cash flow. These may be a single payment note or have a renewal option. The actual working capital needed daily by the partnership may be affected by these liabilities. TAX. RETURNS 69

81 TA X. R E T U R N S TAX. RETURNS 70

82 TA X. R E T U R N S SCHEDULE K-1 (FORM 1120S) PAGE 1 - N O T E S SHAREHOLDER S SHARE OF INCOME, DEDUCTIONS, CREDITS, ETC. The stockholder s share of the S corporation s income or loss is shown here. Part I of the form contains information about the Corporation. Part II contains information about the shareholder. Part III addresses the shareholder s share of income, deductions, credits and other items. TAX. RETURNS Part II Information About the Shareholder Line F Shareholder s Percentage of Stock Ownership This indicates the shareholder s ownership interest for the taxable year, and will determine his or her percentage of profit or loss to be distributed by the S corporation. Part III Shareholder s Share of Current Year Income, Deductions, Credit and Other Items Line 1 Ordinary Business Income (Loss) This is the shareholder s taxable share of ordinary income/loss from the S corporation. Just as with partnerships, shareholders are allocated portions of income/loss, credits, and deductions of the business. The shareholder pays tax or takes deductions on their personal returns for these pass-through items. You may add the ordinary income to qualifying income provided the S corporation has positive sales and earning trends and the borrower can document access to the income. In the event of a loss, subtract the shareholder s percentage of loss from qualifying income. Line 16 Items Affecting Shareholder Basis Similar to partnerships, this represents the fair market value of items distributed to the shareholder. Normally this will be cash only, but other items may be included. It is important to determine the nature and stability of the distributions. 71

83 TA X. R E T U R N S TAX. RETURNS 72

84 TA X. R E T U R N S FORM 1120S - U.S. INCOME TAX RETURN FOR AN S CORPORATION N O T E S This form details the income from an S corporation, which is then shown on the K-1, Schedule E, and Form 1040 for the individual shareholder. As with partnership income, S corporation income is taxable regardless of whether it is distributed to the shareholder. Distributions up to the amount of the shareholder s investment may be treated as a return of investment and will not be reported as taxable income. Careful analysis of the Form 1120S and Schedule K-1 must be exercised when allocating this distribution toward qualifying income of the borrower. TAX. RETURNS S corporations are often used in the early years of a new business due to their ability to pass on start-up costs to their shareholders. Like a partnership or sole proprietorship, the S corporation allows investors to deduct operating losses. Just as important, profits are not taxed twice as they are in regular corporations. A regular corporation itself pays taxes and so do individual investors when those profits are distributed as dividends. Since start-up operations generally have high initial costs, they are substantial risks. Line E Date Incorporated Review this information to determine the age of the S Corporation. Line 5 Other Income (Loss) Analyze this income to determine the probability of it being stable and recurring. Line 7 Compensation of Officers This reflects salaries paid to officers. It should correspond with the borrower s form W-2 (Wage and Tax Statement), if Form 1120S is prepared on a calendar-year basis. Lines 14 and 15 Depreciation and Depletion Financial capacity of the business should be evaluated to ascertain that depreciated assets or depleted resources can be replaced as needed without adversely affecting future business operation. If it is determined that these amounts can be used by the investors without impeding future growth of the business, the amounts on these lines should be multiplied by the borrower s net stock ownership shown on the Schedule K-1 (1120S). Add his or her share of depreciation and depletion back to the borrower s cash flow. 73

85 TA X. R E T U R N S TAX. RETURNS 74

86 TA X. R E T U R N S SCHEDULE L (FORM 1120S) - BALANCE SHEETS N O T E S Line 17 Mortgages, Notes, Bonds Payable In Less Than One Year Research must be done to determine if required repayment of these debts will adversely impact the S corporation s cash flow. These may be a single-payment note or have a renewal option. The actual working capital needed daily by the S corporation and capacity for future growth may be affected by these liabilities. TAX. RETURNS 75

87 TA X. R E T U R N S TAX. RETURNS 76

88 TA X. R E T U R N S FORM U.S. CORPORATION INCOME TAX RETURN N O T E S This form details the earnings of the corporation in income statement format. Schedule L, on the same form, summarizes the corporation s balance sheet. The primary purpose for reviewing the corporate tax return is to analyze the business s financial strength and to confirm that it will continue to generate the income the borrower needs to repay the mortgage loan. TAX. RETURNS If the borrower s share of ownership is 25% or greater, some corporate income may be allocated to qualifying income under certain circumstances. The corporate income tax return should be reviewed and the borrower s pro rata portion of net income may be added to qualifying income. Both the borrower s share of ownership and the corporation s income are shown on Form If the borrower owns less than 25% of the company, he or she is not considered self-employed. Income and employment should be verified using standard verification documentation. Note: The corporation may operate on a fiscal year that is different from a calendar year. The underwriter will have to make time adjustments to relate corporate income to the individual s tax return. The borrower s pro rata portion of corporate income may be added to cash flow provided there is a positive earnings trend, adequate corporate liquidity to fund the withdrawal, and the borrower has documented the right to receive this money. 77

89 TA X. R E T U R N S TAX. RETURNS 78

90 TA X. R E T U R N S Line C N O T E S Date Incorporated Review this information to determine the age of the corporation. Lines 8 and 9 Capital Gain Net Income and Net Gain or (Loss) Analysis must be done to determine the probability of this income being regular and recurring. TAX. RETURNS Line 10 Other Income Analysis must be done to determine the probability of this income being regular and recurring. Lines 20 and 21 Depreciation and Depletion This is a noncash expense representing a replacement reserve for an asset of the corporation that is allocated over the useful life of that asset. Financial capacity of the corporation should be evaluated to ascertain that depreciated assets or depleted natural resources can be replaced as needed without adversely affecting future business operation. If it is determined that these amounts can be used by the borrower without impeding future growth of the business, net depreciation or depletion should be added back to the corporate cash flow. Line 29a Net Operating Loss Deduction Any corporate net operating loss carried over from a prior year may also be added back to corporate cash flow. Line 30 Taxable Income This is the corporation s taxable income and should be added back to corporate cash flow. Line 31 Total Tax This is the tax incurred by the corporation. You must subtract this from the corporation s taxable income. 79

91 TA X. R E T U R N S TAX. RETURNS 80

92 TA X. R E T U R N S SCHEDULE E (FORM 1120) - COMPENSATION OF OFFICERS N O T E S Schedule E of Form 1120 displays salaries paid to officers and their ownership of stock. This can be used for verification of income and can easily be used as a cross-check with the W-2, assuming corporate tax returns are prepared on a calendar-year basis. TAX. RETURNS 81

93 TA X. R E T U R N S TAX. RETURNS 82

94 TA X. R E T U R N S SCHEDULE L (FORM 1120) PAGE 5 - BALANCE SHEETS N O T E S Line 17 Mortgages, Notes, Bonds Payable In Less Than One Year Analysis must be conducted to determine if required repayment of these debts will adversely impact the corporation s cash flow. These may be rollover notes, singlepayment loans or credit lines used for working capital needed daily by the corporation. TAX. RETURNS 83

95 TA X. R E T U R N S TAX. RETURNS 84

96 TA X. R E T U R N S FORM DEPRECIATION AND AMORTIZATION N O T E S The purpose of this form is for the borrower to claim a deduction for depreciation or amortization; make an election under section 179 to expense certain property; and to provide information on the business/investment use of automobiles and other listed property. A separate Form 4562 must be filed for each business or activity for which the form is required. The business or activity to which the form relates is identified on the first line of the form. TAX. RETURNS Line 22 Total This is the total amount of the depreciation that can be claimed by the borrower for this business/activity. The amount will also appear on the applicable form or schedule for this business/activity. A partnership or S corporation does not include any section 179 expense deduction (Line 12) on this line. Instead, any section 179 expense deduction is passed through separately to the partners and shareholders on the appropriate line of their Schedule K-1. 85

97 N O T E S TAX. RETURNS 86

98 Case Study: Sole Proprietor

99

100 C A S E S T U D Y S O L E P R O P R I E T O R ANTHONY AND MARY SOLE-PROPRIETOR Note: In practice, PMI determines qualifying income for self-employed borrowers by developing an average from at least two years tax returns. The purpose of this case study is to review how PMI looks at the 1040 and supporting tax documents. Introduction When underwriting the self-employed borrower, remember that there are many variables beyond the figures on the income tax return that will impact the decision to approve or deny the loan. In fact, the same figures in different circumstances might result in a different underwriting decision. SOLE PROPRIETOR Background Anthony Sole-Proprietor has become a successful art director in the last several years. Anthony started his career at an advertising agency in town. He quickly determined he would become successful and realize his creative potential by starting a business of his own. Starting his own company could also offer his family some flexibility in his work schedule. He is now able to work on-site with his customers and from his home office. The business has been stable with slightly increasing profits. Anthony has concentrated on reducing his business expenses as he becomes more experienced with running his business. Three years ago, Mary left her position as a teacher to stay at home and care for the couple s two children. She plans to return to teaching sometime in the next twelve months. In the meantime, Mary helps Anthony with his bookkeeping. Anthony and Mary retained their first starter home as a rental property. They have had the same lessees for the past twenty two months. Their current home is under contract but will not sell prior to the purchase of their new home and thus, their mortgage payment will be included as a liability. The Sole-Proprietor s do have some stocks and savings accounts; however their down payment will come entirely from a gift given to them by Mary s grandmother. 89

101 C A S E S T U D Y S O L E P R O P R I E T O R 2009 FORM 1040 (PAGE 1) SOLE PROPRIETOR 90

102 C A S E S T U D Y S O L E P R O P R I E T O R 2009 FORM 1040 (PAGE 2) SOLE PROPRIETOR 91

103 C A S E S T U D Y S O L E P R O P R I E T O R 2009 FORM SCHEDULE A&B (PAGE 1) SOLE PROPRIETOR 92

104 C A S E S T U D Y S O L E P R O P R I E T O R 2009 FORM SCHEDULE A&B (PAGE 2) SOLE PROPRIETOR 93

105 C A S E S T U D Y S O L E P R O P R I E T O R 2009 FORM SCHEDULE C (PAGE 1) SOLE PROPRIETOR 94

106 C A S E S T U D Y S O L E P R O P R I E T O R 2009 FORM SCHEDULE C (PAGE 2) SOLE PROPRIETOR 95

107 C A S E S T U D Y S O L E P R O P R I E T O R 2009 FORM SCHEDULE D (PAGE 1) SOLE PROPRIETOR 96

108 C A S E S T U D Y S O L E P R O P R I E T O R 2009 FORM SCHEDULE D (PAGE 2) SOLE PROPRIETOR 97

109 C A S E S T U D Y S O L E P R O P R I E T O R 2009 FORM SCHEDULE E (PAGE 1) SOLE PROPRIETOR 98

110 C A S E S T U D Y S O L E P R O P R I E T O R 2009 FORM 8829 SOLE PROPRIETOR 99

111 C A S E S T U D Y S O L E P R O P R I E T O R 2009 FORM 4562 (PAGE 1) SOLE PROPRIETOR 100

112 C A S E S T U D Y S O L E P R O P R I E T O R 2009 FORM 4562 (PAGE 2) SOLE PROPRIETOR 101

113 C A S E S T U D Y S O L E P R O P R I E T O R 2008 FORM 1040 (PAGE 1) SOLE PROPRIETOR 102

114 C A S E S T U D Y S O L E P R O P R I E T O R 2008 FORM 1040 (PAGE 2) SOLE PROPRIETOR 103

115 C A S E S T U D Y S O L E P R O P R I E T O R 2008 FORM SCHEDULE A&B (PAGE 1) SOLE PROPRIETOR 104

116 C A S E S T U D Y S O L E P R O P R I E T O R 2008 FORM SCHEDULE A&B (PAGE 2) SOLE PROPRIETOR 105

117 C A S E S T U D Y S O L E P R O P R I E T O R 2008 FORM SCHEDULE C (PAGE 1) SOLE PROPRIETOR 106

118 C A S E S T U D Y S O L E P R O P R I E T O R 2008 FORM SCHEDULE C (PAGE 2) SOLE PROPRIETOR 107

119 C A S E S T U D Y S O L E P R O P R I E T O R 2008 FORM SCHEDULE D (PAGE 1) SOLE PROPRIETOR 108

120 C A S E S T U D Y S O L E P R O P R I E T O R 2008 FORM SCHEDULE D (PAGE 2) SOLE PROPRIETOR 109

121 C A S E S T U D Y S O L E P R O P R I E T O R 2008 FORM SCHEDULE E (PAGE 1) SOLE PROPRIETOR 110

122 C A S E S T U D Y S O L E P R O P R I E T O R 2008 FORM 8829 SOLE PROPRIETOR 111

123 C A S E S T U D Y S O L E P R O P R I E T O R 2008 FORM 4562 (PAGE 1) SOLE PROPRIETOR 112

124 C A S E S T U D Y S O L E P R O P R I E T O R 2008 FORM 4562 (PAGE 2)Z SOLE PROPRIETOR 113

125 C A S E S T U D Y S O L E P R O P R I E T O R N O T E S INCOME ANALYSIS OF SOLE PROPRIETOR CASE STUDY The Tax Return One of the things an underwriter should do when examining a tax return is to verify that all information (such as address, number of dependents, and social security numbers) corresponds to the data contained in the loan application. All discrepancies should be explained. SOLE PROPRIETOR Next, in reviewing the tax returns for the Sole-Proprietors, the underwriter should consider the following: Salaried Borrower If one of the borrowers is salaried, income will be reported on the IRS form 1040 under Wages, salaries, tips, etc. Any entry here should be confirmed through a Verification of Employment or pay stubs and W-2s. For 08 add: $0 For 09 add: $0 There is no income reported for this line item. Interest Income Will these assets continue to earn interest? Will any or all of the assets be used for closing costs or the down payment? Are the assets verified and consistent with the information contained in the loan application? These assets will not be liquidated by the Sole-Proprietors. For 08 add: $1,258 For 09 add: $1,600 Dividends In the case of the Sole-Proprietors, there is a two-year history of dividend income. Anthony and Mary will not be liquidating their portfolio. For 08 add: $568 For 09 add: $734 Taxable Refunds of State and Local Taxes Income tax refunds are not considered when determining qualifying income. 114

126 C A S E S T U D Y S O L E P R O P R I E T O R Business Income Anthony Sole-Proprietor, Art Director, has shown consistent stability between 2008 and 2009 business income. Using the Cash Flow Method of income analysis, the net business income (loss) is adjusted by the depreciation expenses (a non-cash item), the 50% exclusion for meals and entertainment and business use of home office expenses. N O T E S For 08: Net business income (loss): $65,363 Depreciation: $5,520 50% meals and entertainment: ($72) Business use of home: $1,147 Add: $71,958 For 09: Net business income (loss): $72,453 Depreciation: $4,013 50% meals and entertainment: ($49) Business use of home: $1,123 Add: $77,540 SOLE PROPRIETOR Capital Gain (Loss) In addition to significant dividend income, there is also a 2-year history of capital gains. The Sole-Proprietors will continue to manage their portfolio for the long run. For 08 add: $1,495 For 09 add: $400 Rents, Royalties, Etc. The rental income has remained stable from 2008 to The underwriter should compare the rents reported on the tax returns to the copies of leases presented in the credit package. Using the Cash Flow Method of income analysis, only actual income and expenses are considered. In this example, depreciation expense will not be included in the total expenses. For 08: Income: $8,100 Expenses: ($6,051) Add: $2,049 For 09: Income: $10,800 Expenses: ($10,067) Add: $733 Other Income The Sole-Proprietors do not have any other income. For 08 add: $0 For 09 add: $0 115

127 N O T E S SOLE PROPRIETOR 116

128 Case Study: S Corporation

129

130 C A S E S T U D Y S C O R P O R AT I O N ADS-R-US/MARK AND MARY APPLICANT Note: In practice, PMI determines qualifying income for self-employed borrowers by developing an average from at least two years tax returns. The purpose of this case study is to review how PMI looks at the 1120S, 1040 and supporting tax documents. Introduction When underwriting the self-employed borrower, remember that there are many variables beyond the figures on the income tax return that will impact the decision to approve or deny the loan. In fact, the same figures in different circumstances might result in a different underwriting decision. Background Mark and Mary are co-owners of an advertising company, Ads-R-Us, which has been in business since Mary has recently taken on a more active role in running Ads-R-Us. Even though her income from Ads-R-Us has remained stable over the past 2 years, the manner in which she is paid has changed. She used to be compensated as an employee (even though she technically owns 50% of the business) until last year, when her earnings were shown as compensation of officers. Mary is also a writer and has claimed income from her writing business as a sole proprietor. She has recently dissolved her writing business so she can spend more of her time on Ads-R-Us. There is documentation in the loan file verifying that the business has been dissolved. Mark and Mary own a couple of rental properties, and have a few other sources of income, including interest and dividends. S.CORPORATION 119

131 C A S E S T U D Y S C O R P O R AT I O N 2009 W-2 - MARY APPLICANT S.CORPORATION 120

132 C A S E S T U D Y S C O R P O R AT I O N 2009 W-2 - MARK APPLICANT S.CORPORATION 121

133 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 1040 (PAGE 1) S.CORPORATION 122

134 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 1040 (PAGE 2) S.CORPORATION 123

135 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM SCHEDULE A&B (PAGE 1) S.CORPORATION 124

136 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM SCHEDULE A&B (PAGE 2) S.CORPORATION 125

137 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM SCHEDULE C (PAGE 1) S.CORPORATION 126

138 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM SCHEDULE C (PAGE 2) S.CORPORATION 127

139 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM SCHEDULE D (PAGE 1) S.CORPORATION 128

140 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM SCHEDULE D (PAGE 2) S.CORPORATION 129

141 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM SCHEDULE E (PAGE 1) S.CORPORATION 130

142 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM SCHEDULE E (PAGE 2) S.CORPORATION 131

143 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 8829 S.CORPORATION 132

144 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 4562 (PAGE 1) S.CORPORATION 133

145 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 1120S - SCHEDULE K-1 S.CORPORATION 134

146 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 1120S - SCHEDULE K-1 S.CORPORATION 135

147 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 1120S (PAGE 1) S.CORPORATION 136

148 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 1120S (PAGE 2) S.CORPORATION 137

149 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 1120S (PAGE 3) S.CORPORATION 138

150 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 1120S (PAGE 4) S.CORPORATION 139

151 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 1120S - SCHEDULE D S.CORPORATION 140

152 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 4562 (PAGE 1) S.CORPORATION 141

153 C A S E S T U D Y S C O R P O R AT I O N 2009 FORM 4562 (PAGE 2) S.CORPORATION 142

154 C A S E S T U D Y S C O R P O R AT I O N 2008 W-2 - MARY APPLICANT S.CORPORATION 143

155 C A S E S T U D Y S C O R P O R AT I O N 2008 W-2 - MARK APPLICANT S.CORPORATION 144

156 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 1040 (PAGE 1) S.CORPORATION 145

157 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 1040 (PAGE 2) S.CORPORATION 146

158 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM SCHEDULE A&B (PAGE 1) S.CORPORATION 147

159 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM SCHEDULE A&B (PAGE 2) S.CORPORATION 148

160 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM SCHEDULE C (PAGE 1) S.CORPORATION 149

161 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM SCHEDULE C (PAGE 2) S.CORPORATION 150

162 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM SCHEDULE D (PAGE 1) S.CORPORATION 151

163 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM SCHEDULE D (PAGE 2) S.CORPORATION 152

164 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM SCHEDULE E (PAGE 1) S.CORPORATION 153

165 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM SCHEDULE E (PAGE 2) S.CORPORATION 154

166 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 8829 S.CORPORATION 155

167 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 4562 (PAGE 1) S.CORPORATION 156

168 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 4562 (PAGE 2) S.CORPORATION 157

169 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 1120S - SCHEDULE K-1 S.CORPORATION 158

170 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 1120S - SCHEDULE K-1 S.CORPORATION 159

171 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 1120S (PAGE 1) S.CORPORATION 160

172 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 1120S (PAGE 2) S.CORPORATION 161

173 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 1120S (PAGE 3) S.CORPORATION 162

174 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 1120S (PAGE 4) S.CORPORATION 163

175 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 4562 (PAGE 1) S.CORPORATION 164

176 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 4562 (PAGE 2) S.CORPORATION 165

177 C A S E S T U D Y S C O R P O R AT I O N 2008 FORM 4562 (PAGE 1) S.CORPORATION 166

178 C A S E S T U D Y S C O R P O R AT I O N INCOME ANALYSIS OF S CORPORATION CASE STUDY N O T E S The Tax Return One of the things an underwriter should do when examining a tax return is to verify that all information (such as address, number of dependents, and social security numbers) corresponds to the data contained in the loan application. All discrepancies should be explained. Next, in reviewing the tax returns for the Applicants, the underwriter should consider the following: Salaried Borrower If one of the borrowers is salaried, income will be reported on the IRS form 1040 under Wages, salaries, tips, etc. Any entry here should be confirmed through a Verification of Employment or pay stubs and W-2s. In 2008, Mary was paid a salary by Ads-R-Us, but in 2009 she was paid officer compensation. Mark was paid officer compensation both years. S.CORPORATION For 08 add: $126,118 For 09 add: $126,118 Interest Income Will these assets continue to earn interest? Will any or all of the assets be used for closing costs or the down payment? Are the assets verified and consistent with the information contained in the loan application? These assets will not be liquidated by the Applicants as part of the down payment. For 08 add: $434 For 09 add: $1,656 Dividends For 08 add: $2,351 For 09 add: $2,967 The Applicants will not liquidate these assets for the down payment. 167

179 C A S E S T U D Y S C O R P O R AT I O N N O T E S Taxable Refunds of State and Local Taxes Income tax refunds are not considered when determining qualifying income. Business Income Mary Applicant has discontinued her writing business, therefore the business income will not be considered. For 08 add: $0 For 09 add: $0 Capital Gain (Loss) The Applicants have shown a capital loss for the past two years. S.CORPORATION For 08 add: ($619) For 09 add: ($12,461) Rents, Royalties, Etc. The rental income has increased significantly from 2008 to The underwriter should compare the rents reported on the tax returns to the copies of leases presented in the credit package. Using the Cash Flow Method of income analysis, only actual income and expenses are considered. In this example, depreciation expense will not be included in the total expenses. For 08: Income: $19,500 Expenses: ($17,205) Add: $2,295 For 09: Income: $24,000 Expenses: ($10,170) Add: $13, Expense Section 179 Expense may be added to income. For 08 add: $24,000 For 09 add: $24,

180 C A S E S T U D Y S C O R P O R AT I O N S Corporation Income Ads-R-Us has shown a significant increase in income between 2008 and Using the Cash Flow Method of income analysis, Mark s and Mary s S Corp income as well as their share of depreciation; depletion; mortgages, notes, bonds payable in less than one year; and other income may be added to income. N O T E S For 08: Schedule E S Corp Income. Add: $45,525 Depreciation/Depletion: $1,800 Mortgages, notes, bonds payable in less than one year: $0 Other income: $0 Subtotal: $1,800 Ownership Percentage: 100% Add: $1,800 For 09: Schedule E S Corp Income. Add $: 177,654 S.CORPORATION Depreciation/Depletion: $4,400 Mortgages, notes, bonds payable in less than one year: $0 Other income: $0 Subtotal: $4,400 Ownership Percentage: 100% Add: $4,400 Other Income The Applicant s do not have any other income. For 08 add: $0 For 09 add: $0 169

181 N O T E S S.CORPORATION 170

182 Case Study: Corporation

183

184 C A S E S T U D Y C O R P O R AT I O N ACME COMPUTER SERVICE, INC./JOE AND JANE BORROWER Note: In practice, PMI determines qualifying income for self-employed borrowers by developing an average from at least two years tax returns. The purpose of this case study is to review how PMI looks at the 1120, 1040 and supporting tax documents. Introduction When underwriting the self-employed borrower, remember that there are many variables beyond the figures on the income tax return that will impact the decision to approve or deny the loan. In fact, the same figures in different circumstances might result in a different underwriting decision. Background Joe Borrower has been a carpenter for ten years. He has been employed by Honest Homebuilder Corp. for the last three years. Jane started a business in the year A college friend, Mary Jones, is her business partner. The two formed a corporation, Acme Computer Service, Inc. They provide computer consultation to small businesses. The business has been a success and profits are increasing. In the last few years, Jane and Mary have been able to hire additional staff to help with the expanding business. Jane also oversees the couple s two rental properties. These are homes the couple acquired five years ago. They purchased homes as fixer-uppers and once Joe remodeled the homes they rented them out. The properties have become a good source of supplemental income for the couple. CORPORATION The Borrower s will retain their current home as a rental with a lease of $1300 per month. They have provided a signed lease to their loan officer for this amount. The payment on their home is $1293 per month (this does include taxes, insurance, HOA dues, etc.). The Borrowers are definitely moving up to a more expensive, larger home that will better fit their needs. The couple will be purchasing their new home with assets from their Fidelity stock fund and their U.S. Bank savings account. 173

185 C A S E S T U D Y C O R P O R AT I O N 2009 W-2 - JANE BORROWER CORPORATION 174

186 C A S E S T U D Y C O R P O R AT I O N 2009 W-2 - JOE BORROWER CORPORATION 175

187 C A S E S T U D Y C O R P O R AT I O N 2009 FORM 1040 (PAGE 1) CORPORATION 176

188 C A S E S T U D Y C O R P O R AT I O N 2009 FORM 1040 (PAGE 2) CORPORATION 177

189 C A S E S T U D Y C O R P O R AT I O N 2009 FORM SCHEDULE A&B (PAGE 1) CORPORATION 178

190 C A S E S T U D Y C O R P O R AT I O N 2009 FORM SCHEDULE A&B (PAGE 2) CORPORATION 179

191 C A S E S T U D Y C O R P O R AT I O N 2009 FORM SCHEDULE E (PAGE 1) CORPORATION 180

192 C A S E S T U D Y C O R P O R AT I O N 2009 FORM 1120 (PAGE 1) CORPORATION 181

193 C A S E S T U D Y C O R P O R AT I O N 2009 FORM 1120 (PAGE 2) CORPORATION 182

194 C A S E S T U D Y C O R P O R AT I O N 2009 FORM 1120 (PAGE 3) CORPORATION 183

195 C A S E S T U D Y C O R P O R AT I O N 2009 FORM 1120 (PAGE 4) CORPORATION 184

196 C A S E S T U D Y C O R P O R AT I O N 2009 FORM 1120 (PAGE 5) CORPORATION 185

197 C A S E S T U D Y C O R P O R AT I O N 2009 FORM 4562 (PAGE 1) CORPORATION 186

198 C A S E S T U D Y C O R P O R AT I O N 2009 FORM 4562 (PAGE 2) CORPORATION 187

199 C A S E S T U D Y C O R P O R AT I O N 2009 FORM 1120 (PAGE 1, LINE 26) CORPORATION 188

200 C A S E S T U D Y C O R P O R AT I O N 2008 W-2 - JANE BORROWER CORPORATION 189

201 C A S E S T U D Y C O R P O R AT I O N 2008 W-2 - JOE BORROWER CORPORATION 190

202 C A S E S T U D Y C O R P O R AT I O N 2008 FORM 1040 (PAGE 1) CORPORATION 191

203 C A S E S T U D Y C O R P O R AT I O N 2008 FORM 1040 (PAGE 2) CORPORATION 192

204 C A S E S T U D Y C O R P O R AT I O N 2008 FORM SCHEDULE A&B (PAGE 1) CORPORATION 193

205 C A S E S T U D Y C O R P O R AT I O N 2008 FORM SCHEDULE A&B (PAGE 2) CORPORATION 194

206 C A S E S T U D Y C O R P O R AT I O N 2008 FORM SCHEDULE E (PAGE 1) CORPORATION 195

207 C A S E S T U D Y C O R P O R AT I O N 2008 FORM 1120 (PAGE 1) CORPORATION 196

208 C A S E S T U D Y C O R P O R AT I O N 2008 FORM 1120 (PAGE 2) CORPORATION 197

209 C A S E S T U D Y C O R P O R AT I O N 2008 FORM 1120 (PAGE 3) CORPORATION 198

210 C A S E S T U D Y C O R P O R AT I O N 2008 FORM 1120 (PAGE 4) CORPORATION 199

211 C A S E S T U D Y C O R P O R AT I O N 2008 FORM 4562 (PAGE 1) CORPORATION 200

212 C A S E S T U D Y C O R P O R AT I O N 2008 FORM 4562 (PAGE 2) CORPORATION 201

213 C A S E S T U D Y C O R P O R AT I O N 2008 FORM 1120 (PAGE 1, LINE 26) CORPORATION 202

214 C A S E S T U D Y C O R P O R AT I O N N O T E S INCOME ANALYSIS OF CORPORATION CASE STUDY The Tax Return One of the things an underwriter should do when examining a tax return is to verify that all information (such as address, number of dependents, and social security numbers) corresponds to the data contained in the loan application. All discrepancies should be explained. Next, in reviewing the tax returns for the Borrowers, the underwriter should consider the following: Salaried Borrower If one of the borrowers is salaried, income will be reported on the IRS form 1040 under Wages, salaries, tips, etc. Any entry here should be confirmed through a Verification of Employment or pay stubs and W-2s. For 08 add: $27,810 For 09 add: $30,780 Since Joe is employed as a carpenter and not selfemployed, only Jane s salary from Acme Computer Services, Inc. should be considered as income from selfemployment. CORPORATION Interest Income Will these assets continue to earn interest? Will any or all of the assets be used for closing costs or the down payment? Are the assets verified and consistent with the information contained in the loan application? These assets will be liquidated by the Borrowers as part of the down payment. For 08 add: $0 For 09 add: $0 203

215 C A S E S T U D Y C O R P O R AT I O N Dividends The borrowers will liquidate these assets for the down payment. N O T E S For 08 add: $0 For 09 add: $0 Taxable Refunds of State and Local Taxes Income tax refunds are not considered when determining qualifying income. Corporate Income Acme Computer Services, Inc. has shown consistent stability and income between 2008 and Using the Cash Flow Method of income analysis, Jane Borrower s share of depreciation; depletion; net operating loss; taxable income/loss; total tax; mortgages, notes, bonds payable in less than one year; and other income may be added to income. CORPORATION For 08: Depreciation/Depletion: $26,000 Net operating loss: $10,158 Taxable income/loss: $200 Total tax: ($30) Mortgages, notes, bonds payable in less than one year: $0 Other income: $0 Subtotal: $36,328 Jane Borrower s Ownership Percentage: 54% Add: $19,617 For 09: Depreciation/Depletion: $15,200 Net operating loss: $8,767 Taxable income/loss: $18,488 Total tax: ($2,773) Mortgages, notes, bonds payable in less than one year: $0 Other income: $0 Subtotal: $39,682 Jane Borrower s Ownership Percentage: 54% Add: $21,

216 C A S E S T U D Y C O R P O R AT I O N N O T E S Capital Gain (Loss) The Borrower s have no capital gains or losses. For 08 add: $0 For 09 add: $0 Rents, Royalties, Etc. The rental income has remained stable from 2008 to The underwriter should compare the rents reported on the tax returns to the copies of leases presented in the credit package. Using the Cash Flow Method of income analysis, only actual income and expenses are considered. In this example, depreciation expense will not be included in the total expenses. For 08: Income: $25,620 Expenses: ($16,122) Add: $9,498 For 09: Income: $27,410 Expenses: ($18,065) Add: $9,345 Other Income The Borrower s do not have any other income. CORPORATION For 08 add: $0 For 09 add: $0 205

217 N O T E S CORPORATION 206

218 Income Analysis Forms

219

220 I N C O M E A N A LY S I S F O R M S INCOME ANALYSIS 209

221 I N C O M E A N A LY S I S F O R M S INCOME ANALYSIS 210

222 I N C O M E A N A LY S I S F O R M S For purposes of this workbook, PMI has used the Cash Flow Method of income analysis for the self-employed borrower. This is generally considered the most comprehensive analysis and provides an in-depth look at the borrower s cash flow and financial condition. N O T E S When underwriting loans for Fannie Mae and Freddie Mac, the Cash Flow Analysis Method should be used. When the self-employment income is from a partnership, S corporation, or corporation, Comparative Income Analysis may be required to analyze the business s financial condition over a period of years. These forms must be included as part of the application package that is submitted to the agency for underwriting performance review. INCOME ANALYSIS 211

223 I N C O M E A N A LY S I S F O R M S FORM 1084 (PAGE 1) INCOME ANALYSIS 212

224 I N C O M E A N A LY S I S F O R M S CASH FLOW ANALYSIS (FANNIE MAE FORM /01) Fannie Mae. Reproduced by permission N O T E S Line 1: Total Income Begin with Total Income, which represents the borrower s gross income before adjustments. Line 2: Wages, Salaries, Tips Subtract any income reported on Form 1040 that has been verified and underwritten based on current information or that does not belong to the borrower. This type of income would include salary and hourly compensation, income from a spouse or ex-spouse that is not applying for mortgage credit, or other income more appropriately underwritten based on current earnings rather than historical. Cross-reference the amount reported on Form 1040 against the amount indicated on the borrower s Form W-2. Line 3: Tax-Exempt Interest Income Add any tax-exempt interest income included on Form 1040 to the Total Income if it is likely to continue and is verified as recurring income. Taxable interest income and dividend income reported on Form 1040 will be addressed by analyzing Schedule B (Form 1040). This analysis should focus on the continuance of any interest or dividend income. Line 4: State and Local Tax Refunds Subtract from Total Income all taxable refunds, credits, or offsets of state and local income taxes reported on Form A tax refund cannot be included as qualifying income since it has been accounted for in the previous year s gross income. Line 5: Nonrecurring Alimony Received Subtract from Total Income any alimony income that does not meet the following criteria: The receipt of alimony income has been documented as stable for at least 12 months, INCOME ANALYSIS The payments will be ongoing and consistent with the level reported on Form 1040 for a minimum of three years, and The alimony payments are made as a result of a divorce decree or written and signed agreement that is a legal obligation. Line 6: Negate Schedule D (Income) Loss Examine Schedule D (Form 1040) to determine whether capital gains should be added to or whether capital losses should be subtracted from Total Income. 213

225 I N C O M E A N A LY S I S F O R M S FORM 1084 (PAGE 1) INCOME ANALYSIS 214

226 I N C O M E A N A LY S I S F O R M S Line 7: Pension and/or IRA Distributions N O T E S The non-taxable portion of IRA distributions, pension, or annuity income is not included in Total Income reported on Form However, total distributions should be used as qualifying income provided the distributions are likely to continue for a minimum of three years and at their reported levels. Pension agreements or account verifications must be obtained to confirm the continuance of this income. On Form 1040, total distributions are reported, however, only the taxable portion of total distributions is included in the borrower s Total Income. To determine the tax-exempt portion of this income, calculate the difference between total distributions and the taxable portion and add the difference to Total Income by recording the calculated amount on Line 7 of our form. The tax-exempt portion of this income can be grossed up according to the guidelines that address tax-exempt income. Line 8: Negate Schedule E (Income) Loss Negate all income (subtract) or loss (add) from rental real estate, royalties, partnerships, S corporations, and trusts. Each component of Schedule E (Form 1040) income (loss) reported on the first page of Form 1040 will be analyzed separately. This approach will help avoid complications that may arise if nondeductible losses occur. Line 9: Nonrecurring Unemployment Compensation Nonrecurring unemployment compensation payments must be subtracted from Total Income. However, if it is typical for the borrower to be laid off seasonally (for example, a construction worker or landscaping laborer), do not subtract the reported amount from Total Income. Unemployment compensation must appear in two consecutive years of tax returns and must be relatively consistent. In addition, the borrower s current job must be subject to the same seasonally affected layoff. If these conditions do not exist, subtract the amount reported from Total Income. Line 10: Social Security Benefits INCOME ANALYSIS Determine the difference between the total and the taxable social security benefits paid to the borrower and add the calculated amount to Total Income. In addition, deduct any nonrecurring taxable benefits. Supporting documentation must be obtained (statement of benefits) to confirm the continuance of this income. Scheduled benefit payments must continue for a minimum of three years to be considered as qualifying income. The tax-exempt portion of this income can be grossed up according to the guidelines that address tax-exempt income. 215

227 I N C O M E A N A LY S I S F O R M S FORM 1084 (PAGE 1) INCOME ANALYSIS 216

228 I N C O M E A N A LY S I S F O R M S Line 11: Nonrecurring Other (Income) Loss N O T E S Subtract other income from the borrower s Total Income unless documentation can be obtained to verify that the receipt of the income will be consistent and ongoing (minimum of three years). Add back other losses to Total Income if documented to be nonrecurring. Adjustments to Income Form 1040 allows for the reduction in Total Income for items such as IRA contributions, moving expenses, various expenses associated with self employment, and others. This worksheet begins with Total Income (Form 1040); therefore, an adjustment is not necessary for these items. Note however, that if the borrower is claiming an adjustment on Form 1040 for alimony paid, this obligation must be factored into the borrower s monthly debt payments to calculate the total debt-to-income ratio. Schedule A (FORM 1040) ITEMIZED DEDUCTIONS A review of Schedule A will give the lender an indication of whether the borrower has owned real estate in the past and if there was a lien against a property (institutional or private). Interest paid on owner-occupied real estate and real estate taxes are itemized on Schedule A. Interest and real estate taxes paid on investment properties are reported on Schedule E (Supplemental Income and Loss). Unreimbursed employee expenses appear on Schedule A and indicate the borrower is subject to certain business expenses that must be factored into the analysis. The lender must obtain and examine Form 2106 if Schedule A indicates the presence of unreimbursed expenses. FORM EMPLOYEE BUSINESS EXPENSES Line 13: Total Expenses The borrower s unreimbursed expenses are reported on Form Subtract the reported amount from Total Income. Note that when the borrower recognizes actual expenses rather than using the standard mileage rate, the lender must analyze the actual expenses section of the form checking for lease payments. Add back actual lease payments to ensure that the expense is recognized only once. INCOME ANALYSIS Line 14: Depreciation If the borrower has claimed automobile depreciation on Form 2106, this expense should be added to the borrower s income. Vehicle depreciation can be calculated one of two ways by using the standard mileage deduction or actual depreciation expense. The method used by the borrower will be disclosed on the second page of Form If the borrower used the standard mileage deduction, multiply the business miles driven by the depreciation factor for the appropriate year and add the calculated amount to Total Income. If the borrower claimed the actual depreciation expense, add this amount to Total Income. 217

229 I N C O M E A N A LY S I S F O R M S FORM 1084 (PAGE 1) INCOME ANALYSIS 218

230 I N C O M E A N A LY S I S F O R M S SCHEDULE B (FORM 1040) INTEREST AND DIVIDEND INCOME N O T E S Line 15: Nonrecurring Interest Income Subtract nonrecurring interest income from Total Income. This includes interest income from assets used to complete the subject transaction. Document the existence of the accounts on which the interest is earned and confirm that the balances have not significantly decreased. Subtract any interest income from seller financed mortgages that have less than three years remaining in the contract or that is unstable because of delinquent repayment. (Note that the principal portion of installment payments received is reported in Schedule D and Form 6252 [Installment Sale Income].) Line 16: Nonrecurring Dividend Income Document that the assets producing dividend income exist and are owned by the borrower. Deduct nonrecurring dividend income from Total Income. SCHEDULE C (FORM 1040) PROFIT OR LOSS FROM BUSINESS: SOLE PROPRIETORSHIP Line 17: Nonrecurring Other (Income) Loss/Expense Other income reported on Schedule C represents income received that was not obtained from the profits of the business. Unless this income is documented and determined to be stable, consistent, and recurring, subtract all Other Income. Line 18: Depletion Add back to Total Income any depletion reported on Schedule C. Line 19: Depreciation Add back to Total Income any depreciation reported on Schedule C. Vehicle depreciation can be calculated one of two ways by using the standard mileage deduction or actual depreciation expense. If the borrower used the standard mileage deduction, multiply the business miles driven by the depreciation factor for the appropriate year and add the calculated amount to the borrower s cash flow. INCOME ANALYSIS Line 20: Travel, Meals, and Entertainment These expenses relate to the cost of business-related travel, meals, and entertainment, and therefore the full amount of these expenses should be taken into account when determining the borrower s actual cash flow. A portion of these expenses is excluded for meals and entertainment, subtract this exclusion from Total Income. 219

231 I N C O M E A N A LY S I S F O R M S FORM 1084 (PAGE 1) INCOME ANALYSIS 220

232 I N C O M E A N A LY S I S F O R M S Line 21: Business Use of Home N O T E S Add to Total Income any expenses for business use of home. Line 22: Amortization/Casualty Loss Amortization expenses are usually one-time costs that are distributed over a period of time and can therefore be added to Total Income. Casualty losses are typically nonrecurring, add them to Total Income. SCHEDULE D (FORM 1040) CAPITAL GAINS AND LOSSES Note that we negated Schedule D gains or losses earlier. Evaluate the consistency and likelihood of continuance of any gains or losses reported on Schedule D. Compare at least two consecutive years of Schedule D to determine whether or not the income or losses are recurring. Confirm the likelihood of continuance by obtaining documentation that supports the borrower s ownership of assets that will produce future gains or losses. Also, ensure that pass-through income from Schedule K-1 is not included. Line 23: Recurring Capital Gains/Losses Add recurring gains to Total Income and deduct recurring losses from Total Income. FORM 4797 SALES OF BUSINESS PROPERTY Line 24: Recurring Capital Gains/Losses Add recurring gains to Total Income and deduct recurring losses from Total Income. INCOME ANALYSIS Form 6252 INSTALLMENT SALE INCOME Line 25: Principal Payments Only gains, losses, and principal repayments are reported on this form (interest income is reported on Schedule B) and are carried forward to Schedule D and Form Schedule D gains or losses were negated in the first part of the analysis. Add principal payments to the borrower s income only when they are determined to be stable and recurring. Obtain a copy of the note or contract to verify that payments will continue for at least three years. 221

233 I N C O M E A N A LY S I S F O R M S FORM 1084 (PAGE 1) INCOME ANALYSIS 222

234 I N C O M E A N A LY S I S F O R M S SCHEDULE E (FORM 1040) RENT AND ROYALTY INCOME N O T E S Income or losses reported on Schedule E was initially negated in the first part of the analysis. In this section of the worksheet, determine to what extent income or losses from real estate rental activities and royalties can be included in the analysis. Income or losses from partnerships and S corporations, which are also included on Schedule E, will be addressed below. Line 26: Gross Rents and Royalties Received Before analyzing the cash flow from rental properties, confirm that the borrower continues to own and rent all properties referenced in the schedule. Cross-reference the schedule of real estate owned as reported on the mortgage application with those listed in Schedule E and with mortgage obligations appearing on the credit report. Add ongoing gross rents received to Total Income. If the borrower has listed royalty income, it should be verified as ongoing and consistent before including it as usable income. Add royalties received to the borrower s income when they are ongoing for three or more years. Line 27: Total Expenses Before Depreciation Subtract from gross rental income the total amount of expenses paid for property maintenance and upkeep. This includes all expenses reported on Schedule E except depreciation. The resulting calculation is the actual income from rental real estate activities. Line 28: Amortization/Casualty Loss/Nonrecurring Expenses A borrower may occasionally claim amortization, casualty losses, or a one-time extraordinary expense, such as a new roof. When an amount is reported in Schedule E for this type of expense, add it back to Total Income. Line 29: Insurance, Mortgage Interest, and Taxes Add back the insurance, mortgage interest, and tax expenses reported on Schedule E when using the full PITI payment for all rental property to calculate the borrower s qualifying ratios. Confirm that PITI payments include all elements insurance, mortgage interest, and taxes. INCOME ANALYSIS The initial step to negate Schedule E income or loss cancelled out the effect of depreciation, depletion, and passive loss limitations on cash flow; therefore, no adjustment is required for either of these items. When using other cash flow worksheets that do not calculate actual losses, add depreciation and depletion expenses to the borrower s income. In addition, determine whether or not any properties were subject to passive loss limitations or used in prior year unallowed losses. Prior year unallowed losses should be added back to cash flow and passive loss limitations should be subtracted. This step is not necessary, however, when using this worksheet. 223

235 I N C O M E A N A LY S I S F O R M S FORM 1084 (PAGE 1) INCOME ANALYSIS 224

236 I N C O M E A N A LY S I S F O R M S SCHEDULE F (FORM 1040) PROFIT OR LOSS FROM FARMING N O T E S Line 30: Non-taxable Portion Ongoing Coop and CCC Payments Certain federal agriculture program payments, co-op distributions, and insurance/loan proceeds are not fully taxable. Add the nontaxable portion of these income types to Total Income. However, caution should be exercised when including them. These sources of income may or may not be stable or continuous. Do not include any income that represents a one-time occurrence or is not stable. Line 31: Nonrecurring Other (Income) Loss Other income reported on Schedule F represents income received by a farmer that was not obtained through farm operations. If this income can not be documented to be stable, consistent, and recurring, subtract Other Income and add Other Losses from income. Line 32: Depreciation Add any depreciation reported on Schedule F to Total Income. Line 33: Amortization/Casualty Loss/Depletion Add amortization, casualty loss, and depletion expenses reported on Schedule F to Total Income. Line 34: Business Use of Home Add expenses for business use of home, as reported on Schedule F, to Total Income. PARTNERSHIP SCHEDULE K-1 (FORM 1065) Line 35: Ordinary Income (Loss) Subtract ordinary losses from the borrower s income. Add ordinary income from the Schedule K-1 to borrower s income only if: INCOME ANALYSIS The business has positive sales and earnings trends. The business has adequate liquidity to support the withdrawal of earnings. (Review the history of withdrawals shown in the analysis of partner s capital account on the first page of the Schedule K-1 to determine a history or pattern of prior withdrawals. Review the partnership s financial position and liquidity to determine the overall ability of the business to support the borrower s withdrawal of earnings.) The borrower can document ownership and access to the income through a partnership resolution. (A majority ownership position, as disclosed on the first page of Schedule K-1 and indicating a majority ownership of capital, will provide sufficient evidence.) 225

237 I N C O M E A N A LY S I S F O R M S FORM 1084 (PAGE 1) INCOME ANALYSIS 226

238 I N C O M E A N A LY S I S F O R M S Line 36: Net Income (Loss) N O T E S Add continuous and ongoing income to the borrower s income if the three conditions listed above are met and the income is not reported elsewhere in the borrower s tax returns. (Note that portfolio income, such as interest, dividends, and royalties listed on Schedule K-1, is reported elsewhere on the 1040, therefore, no adjustment is required.) Subtract ongoing losses from the borrower s income. Line 37: Guaranteed Payments to Partner Add guaranteed payments to partner to the borrower s income when the borrower has at least a 2-year history of having received them. S CORPORATION SCHEDULE K-1 (FORM 1120S) Line 38: Ordinary Income (Loss) Subtract any ordinary losses shown on Schedule K-1 from the borrower s income. Add ordinary income to the borrower s income only if: The business has positive sales and earnings trends. The business has adequate liquidity to support the withdrawal of earnings. (Review the history of distributions and the S corporation s financial position and liquidity to determine the ability of the business to support the borrower s withdrawal of earnings.) The borrower can document ownership and access to the income through a corporate resolution. (A majority ownership position, as disclosed on the first page of Schedule K-1 and indicating a majority ownership of capital, will provide sufficient evidence.) Line 39: Net Income (Loss) Add continuous and ongoing income to the borrower s income if the three conditions listed above are met and the income is not reported elsewhere in the borrower s tax returns. (Note that portfolio income, such as interest, dividends, and royalties listed on Schedule K-1, is reported elsewhere on the 1040, therefore, no adjustment is required.) Subtract ongoing losses from the borrower s income. INCOME ANALYSIS 227

239 I N C O M E A N A LY S I S F O R M S FORM 1084 (PAGE 2) INCOME ANALYSIS 228

240 I N C O M E A N A LY S I S F O R M S BUSINESS CASH FLOW: PARTNERSHIPS, S CORPORATIONS, AND REGULAR CORPORATIONS N O T E S The lender must analyze business tax returns to determine whether income from a partnership, S corporation, or regular corporation can be used to qualify the borrower. The business must show a consistent pattern of profitability for the income to be used. Losses identified by the lender s analysis must be deducted from the borrower s income since they represent a drain on cash flow. PARTNERSHIP FORM 1065 A partnership s distributive earnings and losses are reported on Form 1065 for informational purposes only. The partnership does not pay taxes. Any income or loss is passed through to the partners, with their distributive shares being reported on Schedule K-1 (Form 1065). The borrower s share of ordinary (net) income or loss from a partnership has already been addressed in the evaluation of Schedule K-1 (Form 1065). The analysis of Form 1065 will enable the lender to consider certain adjustments to the ordinary income or losses reported on Schedule K-1. When analyzing Form 1065, only the partner s share of income or loss adjustments should be used to calculate income. The partner s share is based on his or her percentage of capital ownership as reported on the Schedule K-1. The worksheet provides for this calculation. Line 40: Pass-through (Income) Loss from Other Partnerships Income and losses from these sources should generally not be recognized. In this case, the partnership is a partner in another partnership. Before any of this income can be used to qualify the borrower, additional documentation is needed to support distributions that are being made to the borrower s partnership. In addition, the three conditions governing the use of K-1 income must be met relative to the partnership. In general, subtract ordinary income from other partnerships and add any ordinary losses from other partnerships. INCOME ANALYSIS Line 41: Nonrecurring Other (Income) Loss Subtract other income or add other losses that are not consistent and recurring. Line 42: Depreciation Add depreciation to income. 229

241 I N C O M E A N A LY S I S F O R M S FORM 1084 (PAGE 2) INCOME ANALYSIS 230

242 I N C O M E A N A LY S I S F O R M S Line 43: Depletion N O T E S Add depletion to income. Line 44: Amortization/Casualty Loss Add amortization or casualty loss to income. Line 45: Mortgage or Notes Payable in Less than 1 Year These obligations may significantly affect the financial operations of the business. Subtract the amount of mortgage or note obligations payable in less than one year, as reported in Schedule L of Form 1065, end of year column. If there is evidence that these liabilities regularly rollover and/or there are sufficient liquid business assets to cover them, no deduction is necessary. Line 46: Meals and Entertainment Exclusion Subtract the meals and entertainment exclusion reported on Schedule M-1 of Form 1065 from the business income. Line 47: Subtotal Add/subtract all amounts on lines 40 to 46 to determine the amount to be recorded on this line. Line 48: Partnership Total Multiply the subtotal (line 47) by the borrower s ownership share of the partnership. The borrower s share of ownership is based on his or her percentage ownership of capital (at end of year) as reported on the Schedule K-1. INCOME ANALYSIS 231

243 I N C O M E A N A LY S I S F O R M S FORM 1084 (PAGE 2) INCOME ANALYSIS 232

244 I N C O M E A N A LY S I S F O R M S S CORPORATION - FORM 1120S N O T E S Form 1120S represents an S corporation s distributive earnings and losses. This income or loss is reported for taxation purposes to the individual shareholders on Schedule K-1 (Form 1120S). The borrower s share of ordinary (net) income or losses from the business has already been addressed in the evaluation of Schedule K-1 (Form 1120S). The analysis of Form 1120S will enable a lender to consider certain adjustments to the ordinary income or losses reported on Schedule K-1. When analyzing Form 1120S, only the borrower s share of income or loss adjustments should be used to calculate income. The borrower s share is based on his or her percentage of stock ownership as reported on the Schedule K-1. The worksheet provides for this calculation. Line 49: Nonrecurring Other (Income) Loss Subtract other income or add other losses that are not consistent and recurring. Line 50: Depreciation Add depreciation to income. Line 51: Depletion Add depletion to income. Line 52: Amortization/Casualty Loss Add amortization or casualty loss to income. Line 53: Mortgage or Notes Payable in Less than 1 Year These obligations may significantly affect the financial operations of the business. Subtract the amount of mortgage or note obligations payable in less than one year, as reported in Schedule L of Form 1120S, end of year column. INCOME ANALYSIS If there is evidence that these liabilities regularly rollover and/or there are sufficient liquid business assets to cover them, no deduction is necessary. Line 54: Meals and Entertainment Exclusion Subtract the meals and entertainment exclusion reported on Schedule M-1 of Form 1120S from the business income. Line 55: Subtotal Add/subtract all amounts on lines 49 to 54 to determine the amount to be recorded on this line. Line 56: S Corporation Total Multiply the subtotal (line 55) by the borrower s percentage of stock ownership, as reported on the Schedule K

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246 I N C O M E A N A LY S I S F O R M S CORPORATION FORM 1120 N O T E S Line 57: Taxable Income The analysis of corporate income begins with Taxable Income as reported on the first page of Form (Note: Corporate earnings may be used to qualify a borrower only when the borrower can document 100% ownership of the business.) Line 58: Total Tax Corporations are required to pay taxes on earnings (unlike partnerships and S corporations). To determine the available cash flow from the business, subtract the corporation s tax liability from taxable income. Line 59: Nonrecurring (Gains) Losses Determine the likelihood of continuance and stability of capital gains and net gains or losses reported on the first page of Form Subtract nonrecurring gains from the corporation s income and add nonrecurring losses. Line 60: Nonrecurring Other (Income) Loss Subtract nonrecurring other income and add other nonrecurring losses. Line 61: Depreciation Add corporate depreciation to income. Line 62: Depletion Add corporate depletion to income. Line 63: Amortization/Casualty Loss Add corporate amortization or casualty loss to income. INCOME ANALYSIS Line 64: Net Operating Loss and Special Deductions These deductions do not represent actual current expenses or losses. Therefore, add net operating loss and special deductions to the corporation s income. Line 65: Mortgage or Notes Payable in Less than 1 Year These obligations may significantly affect the financial operations of the business. Subtract the amount of mortgage or note obligations payable in less than one year, as reported in Schedule L of Form 1120, end of year column. If there is evidence that these liabilities regularly roll over and/or there are sufficient liquid business assets to cover them, no deduction is necessary. 235

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248 I N C O M E A N A LY S I S F O R M S Line 66: Meals and Entertainment Exclusion N O T E S Subtract the meals and entertainment exclusion reported on Schedule M-1 of Form 1120 from the business income. Line 67: Subtotal Add/subtract all amounts on lines 57 to 66 to determine the amount to be recorded on this line. Line 68: Subtotal Multiplied by Ownership Percentage Multiply the subtotal (line 67) by the borrower s percentage of stock ownership, as reported on the Schedule E (Form 1120) or other independent source. (This must be 100%.) Line 69: Less: Dividends Paid to Borrower Distributions (dividends) paid to stockholders are reported on Schedule M-2 of Form The borrower s share of these distributions will be reported on Schedule B (Form 1040). These funds are also included in the corporation s taxable income and are therefore being double-counted. Therefore, subtract distributions paid by the corporation and reported on the borrower s Schedule B (Form 1040). Line 70: Corporation Total Line 68 less line 69 equals Total Corporation Income. YEAR-TO-DATE INCOME ANALYSIS Year-to-date income from profit and loss statements may only be considered if the income and expenses are consistent with the previous year s performance. Any salaries or draws received by the borrower, as well as any adjustments used when analyzing tax returns, such as nonrecurring income and expenses, depreciation, and depletion, may be added to the business cash flow. Note, however, that these adjustments are limited to the borrower s proportionate share of ownership of the business. INCOME ANALYSIS 237

249 I N C O M E A N A LY S I S F O R M S FORM 1088 INCOME ANALYSIS 238

250 I N C O M E A N A LY S I S F O R M S COMPARATIVE INCOME ANALYSIS (FANNIE MAE FORM 1088) N O T E S This form is used to compare the performance of a self-employed borrower s business over a period of years to determine its viability. Income from one period to the next, covering a period of at least two years, should be compared by calculating the percentage change in the borrower s gross income, expenses, and taxable income. Gross income equals gross receipts (or sales) less returns and allowances. Expenses equal cost of goods sold plus total deductions. Taxable income is taken from one of the following IRS forms: U.S. Income Tax Return (IRS Form 1040), Schedule C, for the net profit or loss for a sole proprietorship. U.S. Partnership Return of Income (IRS Form 1065), for ordinary income or loss for a partnership. U.S. Corporation Income Tax Return (IRS Form 1120), for taxable income for a corporation. U.S. Income Tax Return for an S Corporation (IRS Form 1120S), for taxable income for an S Corporation (a small, start-up business). GROSS INCOME Step 1 Enter the gross income for each period. Step 2 Calculate the percentage change by subtracting the most recent year from the previous year and dividing the difference by the previous year s gross income. EXPENSES INCOME ANALYSIS Step 1 Enter the expenses for each period. Step 2 Divide the expense amount by the gross income for each year to determine the relationship of income to expense year-over-year. Step 3 Calculate the percentage change by subtracting the most recent year from the previous year and dividing the difference by the previous year s expense. 239

251 I N C O M E A N A LY S I S F O R M S FORM 1088 INCOME ANALYSIS 240

252 I N C O M E A N A LY S I S F O R M S TAXABLE INCOME N O T E S Step 1 Enter the taxable income figure for each period. Step 2 Divide the taxable income amount by the gross income for each year to determine if the taxable income trend is increasing, level, or decreasing. Step 3 Calculate the percentage change by subtracting the most recent year from the previous year and dividing the difference by the previous year s taxable income. INCOME ANALYSIS 241

253 N O T E S INCOME ANALYSIS 242

254 Red Flags

255

256 R E D F L A G S The following list is to be used to review tax returns in conjunction with the borrower s loan application. If any of these conditions exist, further analysis may be required. N O T E S Here are some red flags to watch out for Name, address, social security number, or corporation is inconsistent with information in the loan file. The number of dependents does not agree with the Obvious income/deduction calculations. Wages do not agree with W-2s or VOE in the file. Business income is inconsistent with the net income on the Schedule C. Unemployment compensation was claimed but the file does not show a gap in employment or that there is seasonal employment. Deductions were made for one-half self-employed health insurance for a borrower who does not claim self-employment. Evidence of white-out or other alterations. The type of handwriting varies within the return. No estimated tax payments by self-employed borrower (schedule SE required). Paid preparer signs taxpayer s copy. High-income borrower and self-prepared tax returns. Occupation differs from what was stated on the Real Estate taxes paid, but no property shown on Schedule of Real Estate. Schedules missing from file. Handwritten return when prepared by professional. Self-employed borrower who shows salaried wages instead of business income. No deductions have been taken or incorrect deductions have been taken. SCHEDULE A Real estate taxes and/or mortgage interest is paid, but the application shows no ownership. Borrower owns property, but doesn t pay real estate taxes and/or mortgage interest. State income tax was paid by borrower who lives and works in a state that does not have income tax. Borrower pays large amounts of interest, but few creditors are shown on the mortgage application or credit report. RED. FLAGS 245

257 R E D F L A G S N O T E S SCHEDULE B No dividends are earned on stock owned. Borrower with substantial cash in bank shows little or no related interest income. SCHEDULE C Income appears high for the type of business listed on schedule C. Numbers are incorrectly added. Income does not agree with total income on 1099 forms. No cost of goods sold on retail or similar type of business. The borrower takes a depreciation deduction for real estate that is not disclosed on the application. There is interest expense with no related loan disclosed on the application. There are no deductions for tax and licenses. Borrower s wages are paid, but no tax expense is claimed. Business expenses are not consistent with the type of business (i.e., truck driver doesn t claim a car or truck expense). SCHEDULE E The schedule of Real Estate differs from the properties listed on the Schedule E. Mortgage interest is deducted as an expense for the subject property, but there is no loan listed on the application. Property taxes and insurance was not expensed for rental properties. Pass through of tax liability is reported from partnerships and S-corporations and is not consistent with the K-1 Schedule. R E D. F L A G S 246

258 Glossary

259

260 G L O S S A RY Accelerated Cost Recovery System (ACRS) A method of depreciation that permits a larger portion of the CAPITAL ASSET to be expensed in the early years of its estimated useful life. Accounts Payable Represents amounts owed to regular business creditors from whom the company has bought goods or services on an open account. This is a LIABILITY. These claims are referred to as NOTES PAYABLE. Accounts Receivable Represents amounts or payments due from customers for goods or services sold to them. These claims are referred to as NOTES RECEIVABLE. Accrual Method of Accounting A method of accounting, matching revenues and expenses to the period when they occur regardless of whether payment has been made or received. Revenues are recognized when goods are sold or services performed, even though payment has not been received. Expenses are recognized when they are incurred and not when paid. This method is often used by farmers and by businesses that carry inventories. Adjusted Basis The original cost of an asset less depreciation, first-year expense amortization, casualty or theft losses, and increased by capital improvements. Adjusted Gross Gross income reduced by adjustments allowed by IRS rules. Income (AGI) Amortization The process of apportioning the cost of an intangible asset over a specified period. A deductible expense allowed as a means of recapturing a business investment in an intangible asset (i.e., GOODWILL, TRADEMARK). Annuity A sum of money paid periodically that includes the invested capital (principal) plus income generated by it. Frequently used with retirement plans in order to pay pensions. Assets Items of value that are owned and carried on the books at historical cost. Assets are shown on the balance sheet in order of liquidity (i.e., the promptness with which they can be converted into cash). Balance Sheet The report of assets, liabilities, and owner s equity showing the financial position of a business as of a given point in time. Capital Represents funds belonging to the owners of a business, invested with the intention that the funds will remain in the business as a means of generating income. Also referred to as EQUITY, OWNER S EQUITY, STOCKHOLDER S EQUITY, or NET WORTH. G LOSSARY 249

261 G L O S S A RY Capital Assets An asset of a permanent or fixed nature. Capital Expenditures The cost of additions and improvements to property that increase value or useful life. The entire cost of a capital expenditure may not be deducted in the first year, but rather depreciated to recover its cost over a period of several years. Capital Gains and Losses A gain or loss resulting from the sale or exchange of a CAPITAL ASSET. This may be computed by comparing the amount received from sale/exchange with the purchase price plus improvements (ADJUSTED BASIS). Capital Gain Dividend A distribution by a company to its shareholders from the sale of a portion of its portfolio. Capital Loss Carryover The excess of a capital loss over capital gain that may not be deducted in a particular year. This amount will be carried forward and reported in another year. Capital Stock The account represents the shares of investment in a business by its shareholders. Capital Surplus The amount paid by shareholders that exceeds the par value of each share. Cash Funds that are immediately available for disbursement. Cash Method of Accounting A method of accounting that recognizes income when actually received and expenses when actually paid. Common Stock Represents ownership or investment in an entity. The shareholder has a claim position against the assets of the entity. Dividends may be paid on the stock held. Costs of Goods Sold The actual cost to develop, transport, and maintain a product or service for customers (i.e., cost of materials purchased during a particular time period, plus beginning inventory, minus ending inventory). Current Assets Cash and other resources readily convertible to cash in the normal course of business. Current assets can be expected to be sold or consumed within one year. G L O S S A R Y Current Liabilities Obligations due within 12 months of the date of the statement and that will require the use of current assets. 250

262 G L O S S A RY Declining-Balance Depreciation A method of accelerated depreciation by which each year s depreciation is a percentage of the reduced basis of the asset. Deductions Payments or expenses allowed by IRS rules to reduce taxable income. Deferred Income The liability that occurs when a business receives payment in advance for a service. Deferred Expenses Expenses incurred that will be paid at a future date. Deferred Gain A gain realized but not taxable until a later date. Depletion Represents the loss in value of a natural resource asset, such as oil and gas. The asset is used up and must be replaced. The loss in value is recognized as a cost (expense) and is used to reduce taxable income. No actual expense to the individual is incurred. Depreciable Asset Assets used in a business or held for the production of income with a useful life exceeding one year; qualifying for a depreciation deduction. Depreciation An expense representing the loss in value of property. The loss is recognized as a cost and reduces taxable income. No actual cost or expense is incurred. Estimated Tax An amount of tax that must be remitted quarterly to the IRS on Form 1040ES if you are self-employed or expected to receive untaxed income. Exclusion An amount that is excluded from taxable income. Exemptions A specific dollar deduction from ADJUSTED GROSS INCOME (AGI) for the taxpayer and each dependent. Expenses Necessary costs incurred in doing business. Fiduciary An individual or trustee who has discretionary authority to receive and manage property or assets on behalf of another. Finance Charges Interest payments made on a deferred debt. Fiscal Year A 12-month period ending on the last day of any month other than December. G LOSSARY 251

263 G L O S S A RY Fixed Assets Those assets that are not intended for sale, but are used continuously to produce a product or offer a service. These assets may consist of, but are not limited to, land, buildings, equipment, etc. Goodwill An intangible asset on a company s balance sheet that represents a premium for the company s reputation with the public. Income Statement A summary of an organization s revenue and expenses for a specific period of time. Also called profit and loss statement, statement of earning, or statement of operation. Installment Method A method of reporting the gain from a sale of an asset through the years the payments are received, instead of reporting the entire amount in the year of the sale. Intangible Assets Nonphysical assets owned by the company. This is property with its value assigned by contract, such as a franchise, and customer lists. These are also original works created (or acquired) under the laws governing intellectual property, such as copyrights and patents. Inventories Items of tangible property that may be 1) held for sale as a product, 2) in process of production for sale as a product, or 3) used for producing goods or services that will be available for sale. Liabilities Debts or obligations with a specified maturity date, payable to a specific party in a specific manner. Liquid Assets Assets that are normally converted and used within a 1-year period. Long-Term Capital Gain or Loss Gain or loss realized from the sale/exchange of a capital asset that has been held for a minimum period of time. Long-Term Liabilities Liabilities that will not be due within one year of the date of the balance sheet, such as mortgages and bonds. Marketable Securities Securities representing a company s temporary investment of cash in safe, highly liquid instruments for interest or dividend yield. G L O S S A R Y Net Operating Loss (NOL) Nonpassive Income A business loss that exceeds current income. A NOL may be carried back three years or carried forward for 15 years to reduce taxable income in one or more of these years. Income that an individual derives from a business in which the individual materially participates, such as wages, tips and profits, and portfolio income, such as interest and dividends. 252

264 G L O S S A RY Notes Payable Financial obligation evidenced by a note or other written acknowledgment of debt. Notes Receivable Amounts owed evidenced by a note or other written acknowledgment of debt. Ordinary Income or Loss Any profit (or loss) from the sale of assets used in your trade or business. Owner s Equity Claims of the owner (stockholder s equity) or the owners interest (net worth). Passive Income Income that an individual derives from real estate and business activities in which the individual does not materially participate, such as real estate rentals and limited partnerships. Pension Payment made from an employer-funded retirement plan for past services. Preferred Stock A form of capital stock that receives precedence over corporate bonds but are below common stock in terms of protection to the investor. Preferred stockholders have a priority claim against both current earnings and assets, but in event of liquidation, can recover their funds only after payment to bondholders and other creditors. Real Property Physical property that is permanent and immovable, such as land and buildings. Retained Earnings Represents earned income that is not dispersed in the form of salaries and/or dividends at year s end. Revenue An inflow of assets, not necessarily cash, in exchange for goods and services sold. Royalty Income Income received for the use of certain types of property. Short-Term Capital Gain or Loss Gain or loss on the sale/exchange of a capital asset that has been held less than the legislatively mandated time period. Tangible Personal Property Physical properties that can be moved, such as office equipment, machinery, and automobiles. Trust An entity to which assets are transferred for protection, management, and distribution in accordance with the terms of a trust document. G LOSSARY 253

265 N O T E S G L O S S A R Y 254

266 Appendix

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268 A P P E N D I X 2009 FORM 2106-EZ (PAGE 1) 257 A PPENDIX

269 A P P E N D I X 2009 FORM 2106-EZ (PAGE 3) A P P E N D I X 258

270 A P P E N D I X 2009 FORM 2106-EZ (PAGE 4) 259 A PPENDIX

271 A P P E N D I X 2009 FORM 4506 (PAGE 1) A P P E N D I X 260

272 A P P E N D I X 2009 FORM 4506 (PAGE 2) 261 A PPENDIX

273 A P P E N D I X 2009 FORM 4506-T (PAGE 1) A P P E N D I X 262

274 A P P E N D I X 2009 FORM 4506-T (PAGE 2) 263 A PPENDIX

275 N O T E S A P P E N D I X 264

276 ( PMI ) is providing this publication, Underwriting the Self Employed Borrower, to you for use as a training tool only. This book and any related materials are not intended nor should they be relied upon for any other purpose, including underwriting actual mortgage loans without independent verification and testing by your inhouse quality control and/or compliance personnel or actual preparation of documents, including tax forms, which may be presented in the materials. All materials presented are samples for illustrative purposes only. Please direct any questions you may have about this or any other PMI training publication to your PMI representative or call PMI (4764) PMI (4764) pmianswercenter@pmigroup.com PMI 174 (05.10)