UNDERWRITING THE SELF-EMPLOYED BORROWER

Transcription

1 UNDERWRITING THE SELF-EMPLOYED BORROWER Arch Mortgage Insurance Company CU

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3 Table of Contents Introduction Automated Underwriting & the Self-Employed Borrower...1 Basic Business Structures... 5 Feature Comparison... 7 Description of Business Structures... 8 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 1125-E - Compensation of Officers Form U.S. Corporation Income Tax Return Form 1120 Schedule L - Balance Sheets per Books Profit and Loss Statement Balance Sheet Arch Mortgage Insurance Company ( Arch MI ) 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 in-house 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 Arch MI training publication to your Arch MI representative or call Arch Mortgage Insurance Company UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL III

4 Introduction 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. In this discussion, we will review federal tax returns to determine qualifying income for the self-employed borrower. Although our main focus is on the self-employed borrower, we will also discuss other types of variable income that may be available for debt repayment. Underwriting a mortgage loan requires a sensitive analysis of the 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 discussion addresses the borrower s capacity to manage debt. iv UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL Arch Mortgage Insurance Company

5 Effect of DU/LP on Underwriting SEB

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7 Automated Underwriting & The Self-Employed Borrower In view of the important role played by automated underwriting in the origination of conventional loans in today s marketplace, Arch MI feels that it is prudent to discuss its impact on the underwriting process in our Self- Employed Borrower manual. NOTESN 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 self-employed 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. 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. As noted above, DU or LP may allow for documentation levels that are less than Arch MI s standard documentation requirements. However, Arch MI may allow these documentation efficiencies provided the loan receives a DU Approve/Eligible or a LP Accept. Further, the lender must prepare a written evaluation of its analysis of the borrower s self-employed income. Arch Mortgage Insurance Company UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL 3

8 Notes 4 UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL Arch Mortgage Insurance Company

9 Basic Business Structures

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11 Basic Business Structures 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. 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. Arch Mortgage Insurance Company UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL 7

12 Basic Business Structures DESCRIPTION OF EACH BUSINESS STRUCTURE Sole Proprietorships A sole proprietorship is an unincorporated business that is individually owned and managed. The individual owner has unlimited personal liability for all debts of the business. If the business fails, the borrower not only will have to replace his or her lost income, but also will be expected to satisfy the outstanding obligations of the business. Since no distinction is made between the owner s personal assets and the assets used in the business, creditors may take either (or both) to satisfy the borrower s business obligations. The financial success or failure of this type of business depends on the owner s ability to obtain capital and to manage the various aspects of the business. Poor management skills or an inability to secure capital to keep the business running will compromise the continuance of the borrower s business (and income). The owner s death terminates the business and may cause the assets to be placed into probate, thus delaying the disposition of the assets to creditors and heirs. Partnerships A partnership is an arrangement between two or more individuals who have pooled their assets and skills to form a business and who will share profits and losses according to predetermined proportions that are set out in the partnership agreement. A partnership may be either a general partnership or a limited partnership: General Partnership Under a general partnership, each partner has responsibility for running the business, is personally liable for the debts of the entire business, and is responsible for the actions of every other partner (unless otherwise specified in the partnership agreement). A general partnership is dissolved immediately on the death, withdrawal, or insolvency of any of the partners, although the personal liability to partnership creditors exists even after the partnership is dissolved. However, the partnership s assets will first be applied to the creditors of the business and the partners individual assets will be first be applied to their personal creditors, with any surplus in a partner s personal assets then being applied to the remaining business creditors. Limited Partnership Under a limited partnership, a limited partner has limited liability based on the amount he or she invested in the partnership, does not typically participate in the management and operation of the business, and has limited decision-making ability. A limited partnership will have at least one general partner who manages the business and is personally liable for the debts of the entire business. 8 UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL Arch Mortgage Insurance Company

13 Basic Business Structures A limited partner s death, withdrawal, or insolvency does not dissolve the partnership. Because limited partnerships often are formed as tax shelters, it is more likely that IRS Form 1065, Schedule K-1, will reflect a loss instead of income. In such cases, the borrower s ability to deduct the loss will be limited by the at risk amount of his or her limited partnership interest (and will probably be subject to passive loss limitations). Corporations A corporation is a state-chartered legal entity that exists separately and distinctly from its owners (who are called stockholders or shareholders). It is the most flexible form of business organization for purposes of obtaining capital. A corporation can sue; be sued; hold, convey, or receive property; enter into contracts under its own name; and does not dissolve when its ownership changes. There are two types of corporations publicly owned (widely held) corporations and privately owned (closely held) corporations. Because more than 50% of the outstanding stock of a privately owned corporation is owned directly or indirectly by no more than five people, the corporation has little or no access to public funds and must raise capital through institutional financing. Although legal control of the corporation rests with its stockholders, they typically are not responsible for the day-to-day operations of the business since they elect a board of directors to manage the corporation and delegate responsibility for the day-to-day operations to the directors and officers of the company. The distribution of profits earned by the business is determined by the corporation s board of directors or other entities that have a significant financial interest in the business. However, the profits usually are filtered down to the owners in the form of dividends. Since a stockholder is not personally liable for the debts of the corporation, losses are limited to his or her individual investment in the corporation s stock. Corporations must report income and losses on IRS Form 1120 and pay taxes on the net income. The corporation distributes profits to its shareholders in the form of dividends, which it reports on IRS Form 1099-DIV. The shareholders must then report the dividends as income on their individual IRS Form S Corporations An S corporation is a legal entity that has a limited number of stockholders and elects not to be taxed as a regular corporation. Business gains and losses are passed on to the stockholders. An S corporation has many of the characteristics of a partnership. Stockholders are taxed at their individual tax rates for their proportionate share of ordinary income, capital gains, and other taxable items. Arch Mortgage Insurance Company UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL 9

14 Basic Business Structures The ordinary income for an S corporation is reported on IRS Form 1120S, with each shareholder s share of the income reported on IRS Form 1120S, Schedule K-1. Because this income from the distribution of corporate earnings may or may not be distributed to the individual shareholders, the lender should determine if the borrower received a cash distribution from the S corporation. The cash flow of an S corporation is otherwise evaluated similarly to that of a regular corporation. Limited Liability Companies A limited liability company (LLC) is a hybrid business structure that is designed to offer its member-owners the tax efficiencies of a partnership and the limited liability advantages of a corporation. The member-owners of the LLC (or their assigned managers) can sign contracts, sell assets, and make other important business decisions. The LLC operating agreement may set out specific divisions of power among the member-owners (or managers). Although the member-owners generally have limited liability, there may be some instances in which they are required to personally guarantee some of the loans that the LLC obtains. Profits from the operation of the LLC may be distributed beyond the pool of member-owners, such as by offering profit distributions to managers. The LLC must report its profit or loss on IRS Form 1065 and each member-owner s share of the profit or loss on IRS Form 1065, Schedule K-1; however, the LLC pays no tax on its income. Each member-owner uses the information from Schedule K-1 to report his or her share of the LLC s net profit or loss (and special deductions and credits) on his or her individual IRS Form 1040, whether or not the member-owner receives a cash distribution from the LLC. Individual member-owners pay taxes on their proportionate share of the LLC s net income at their individual tax rates. Note: These business structure definitions were derived from FNMA Business Structures dated 3/2/2010. Arch Mortgage Insurance Company UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL 10

15 Tax Returns

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17 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. 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 2106 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. Employee Business Expenses - used to report reimbursed and unreimbursed business expenses. 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. Arch Mortgage Insurance Company UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL 13

18 PARTNERSHIP STATEMENTS Tax Forms and Schedules Form 1065 Schedule L (1065) Schedule K-1 (1065) Form 4562 Description 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 whether the borrower is a limited partner, a general partner or a limited liability company (LLC), each partner s capital account, the individual partner s percentage of ownership, and outlines the profit and loss of a partner. 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 Form 1125-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. 14 UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL Arch Mortgage Insurance Company

19 TAX RETURN FORMS AND SUPPORTING SCHEDULES S K F K S CORPORATION E 1125-E 1120 A&B C D PARTNERSHIP 1040 SOLE PROPRIETOR CORPORATION INDIVIDUAL TAXPAYER Arch Mortgage Insurance Company UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL 15

20 Department of the Treasury Internal Revenue Service (99) 1040 U.S. Individual Income Tax Return 2013 OMB No IRS Use Only Do not write or staple in this space. For the year Jan. 1 Dec. 31, 2013, or other tax year beginning, 2013, ending, 20 See separate instructions. Form Your first name and initial Last name Your social security number If a joint return, spouse s first name and initial Last name Spouse s social security number Home address (number and street). If you have a P.O. box, see instructions. Apt. no. Make sure the SSN(s) above and on line 6c are correct. City, town or post office, state, and ZIP code. If you have a foreign address, also complete spaces below (see instructions). Presidential Election Campaign Foreign country name Foreign province/state/county Check here if you, or your spouse if filing jointly, want $3 to go to this fund. Checking Foreign postal code a box below will not change your tax or refund. You Spouse Filing Status 1 Single 4 Head of household (with qualifying person). (See instructions.) If 2 Married filing jointly (even if only one had income) the qualifying person is a child but not your dependent, enter this Check only one 3 Married filing separately. Enter spouse s SSN above child s name here. box. and full name here. 5 Qualifying widow(er) with dependent child 6a Yourself. If someone can claim you as a dependent, do not check box 6a..... Boxes checked Exemptions } on 6a and 6b b Spouse No. of children c Dependents: (2) Dependent s (3) Dependent s (4) if child under age 17 on 6c who: (1) First name Last name social security number relationship to you qualifying for child tax credit lived with you (see instructions) did not live with you due to divorce If more than four dependents, see instructions and check here or separation (see instructions) Dependents on 6c not entered above Add numbers on d Total number of exemptions claimed lines above Income 7 Wages, salaries, tips, etc. Attach Form(s) W a Taxable interest. Attach Schedule B if required a b Tax-exempt interest. Do not include on line 8a... 8b Attach Form(s) 9 a Ordinary dividends. Attach Schedule B if required a W-2 here. Also attach Forms b Qualified dividends b W-2G and 10 Taxable refunds, credits, or offsets of state and local income taxes R if tax 11 Alimony received was withheld. 12 Business income or (loss). Attach Schedule C or C-EZ Capital gain or (loss). Attach Schedule D if required. If not required, check here 13 If you did not 14 Other gains or (losses). Attach Form get a W-2, see instructions. 15 a IRA distributions. 15a b Taxable amount... 15b 16 a Pensions and annuities 16a b Taxable amount... 16b 17 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E Farm income or (loss). Attach Schedule F Unemployment compensation a Social security benefits 20a b Taxable amount... 20b 21 Other income. List type and amount Combine the amounts in the far right column for lines 7 through 21. This is your total income Educator expenses Adjusted 24 Certain business expenses of reservists, performing artists, and Gross fee-basis government officials. Attach Form 2106 or 2106-EZ 24 Income 25 Health savings account deduction. Attach Form Moving expenses. Attach Form Deductible part of self-employment tax. Attach Schedule SE Self-employed SEP, SIMPLE, and qualified plans Self-employed health insurance deduction Penalty on early withdrawal of savings a Alimony paid b Recipient s SSN 31a 32 IRA deduction Student loan interest deduction Tuition and fees. Attach Form Domestic production activities deduction. Attach Form Add lines 23 through Subtract line 36 from line 22. This is your adjusted gross income For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see separate instructions. Cat. No B Form 1040 (2013) 16 UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL Arch Mortgage Insurance Company

21 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 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 interest 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), the asset is documented appropriately 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, receipt of the income is documented appropriately and the income will continue to be received for at least three years after loan closing. Line 9a Ordinary 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. Arch Mortgage Insurance Company UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL 17

22 Department of the Treasury Internal Revenue Service (99) 1040 U.S. Individual Income Tax Return 2013 OMB No IRS Use Only Do not write or staple in this space. For the year Jan. 1 Dec. 31, 2013, or other tax year beginning, 2013, ending, 20 See separate instructions. Form Your first name and initial Last name Your social security number If a joint return, spouse s first name and initial Last name Spouse s social security number Home address (number and street). If you have a P.O. box, see instructions. Apt. no. Make sure the SSN(s) above and on line 6c are correct. City, town or post office, state, and ZIP code. If you have a foreign address, also complete spaces below (see instructions). Presidential Election Campaign Foreign country name Foreign province/state/county Check here if you, or your spouse if filing jointly, want $3 to go to this fund. Checking Foreign postal code a box below will not change your tax or refund. You Spouse Filing Status 1 Single 4 Head of household (with qualifying person). (See instructions.) If 2 Married filing jointly (even if only one had income) the qualifying person is a child but not your dependent, enter this Check only one 3 Married filing separately. Enter spouse s SSN above child s name here. box. and full name here. 5 Qualifying widow(er) with dependent child 6a Yourself. If someone can claim you as a dependent, do not check box 6a..... Boxes checked Exemptions } on 6a and 6b b Spouse No. of children c Dependents: (2) Dependent s (3) Dependent s (4) if child under age 17 on 6c who: (1) First name Last name social security number relationship to you qualifying for child tax credit lived with you (see instructions) did not live with you due to divorce If more than four dependents, see instructions and check here or separation (see instructions) Dependents on 6c not entered above Add numbers on d Total number of exemptions claimed lines above Income 7 Wages, salaries, tips, etc. Attach Form(s) W a Taxable interest. Attach Schedule B if required a b Tax-exempt interest. Do not include on line 8a... 8b Attach Form(s) 9 a Ordinary dividends. Attach Schedule B if required a W-2 here. Also attach Forms b Qualified dividends b W-2G and 10 Taxable refunds, credits, or offsets of state and local income taxes R if tax 11 Alimony received was withheld. 12 Business income or (loss). Attach Schedule C or C-EZ Capital gain or (loss). Attach Schedule D if required. If not required, check here 13 If you did not 14 Other gains or (losses). Attach Form get a W-2, see instructions. 15 a IRA distributions. 15a b Taxable amount... 15b 16 a Pensions and annuities 16a b Taxable amount... 16b 17 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E Farm income or (loss). Attach Schedule F Unemployment compensation a Social security benefits 20a b Taxable amount... 20b 21 Other income. List type and amount Combine the amounts in the far right column for lines 7 through 21. This is your total income Educator expenses Adjusted 24 Certain business expenses of reservists, performing artists, and Gross fee-basis government officials. Attach Form 2106 or 2106-EZ 24 Income 25 Health savings account deduction. Attach Form Moving expenses. Attach Form Deductible part of self-employment tax. Attach Schedule SE Self-employed SEP, SIMPLE, and qualified plans Self-employed health insurance deduction Penalty on early withdrawal of savings a Alimony paid b Recipient s SSN 31a 32 IRA deduction Student loan interest deduction Tuition and fees. Attach Form Domestic production activities deduction. Attach Form Add lines 23 through Subtract line 36 from line 22. This is your adjusted gross income For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see separate instructions. Cat. No B Form 1040 (2013) 18 UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL Arch Mortgage Insurance Company

23 Line 10 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. N O T E S Line 11 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. 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. Arch Mortgage Insurance Company UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL 19

24 Department of the Treasury Internal Revenue Service (99) 1040 U.S. Individual Income Tax Return 2013 OMB No IRS Use Only Do not write or staple in this space. For the year Jan. 1 Dec. 31, 2013, or other tax year beginning, 2013, ending, 20 See separate instructions. Form Your first name and initial Last name Your social security number If a joint return, spouse s first name and initial Last name Spouse s social security number Home address (number and street). If you have a P.O. box, see instructions. Apt. no. Make sure the SSN(s) above and on line 6c are correct. City, town or post office, state, and ZIP code. If you have a foreign address, also complete spaces below (see instructions). Presidential Election Campaign Foreign country name Foreign province/state/county Check here if you, or your spouse if filing jointly, want $3 to go to this fund. Checking Foreign postal code a box below will not change your tax or refund. You Spouse Filing Status 1 Single 4 Head of household (with qualifying person). (See instructions.) If 2 Married filing jointly (even if only one had income) the qualifying person is a child but not your dependent, enter this Check only one 3 Married filing separately. Enter spouse s SSN above child s name here. box. and full name here. 5 Qualifying widow(er) with dependent child 6a Yourself. If someone can claim you as a dependent, do not check box 6a..... Boxes checked Exemptions } on 6a and 6b b Spouse No. of children c Dependents: (2) Dependent s (3) Dependent s (4) if child under age 17 on 6c who: (1) First name Last name social security number relationship to you qualifying for child tax credit lived with you (see instructions) did not live with you due to divorce If more than four dependents, see instructions and check here or separation (see instructions) Dependents on 6c not entered above Add numbers on d Total number of exemptions claimed lines above Income 7 Wages, salaries, tips, etc. Attach Form(s) W a Taxable interest. Attach Schedule B if required a b Tax-exempt interest. Do not include on line 8a... 8b Attach Form(s) 9 a Ordinary dividends. Attach Schedule B if required a W-2 here. Also attach Forms b Qualified dividends b W-2G and 10 Taxable refunds, credits, or offsets of state and local income taxes R if tax 11 Alimony received was withheld. 12 Business income or (loss). Attach Schedule C or C-EZ Capital gain or (loss). Attach Schedule D if required. If not required, check here 13 If you did not 14 Other gains or (losses). Attach Form get a W-2, see instructions. 15 a IRA distributions. 15a b Taxable amount... 15b 16 a Pensions and annuities 16a b Taxable amount... 16b 17 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E Farm income or (loss). Attach Schedule F Unemployment compensation a Social security benefits 20a b Taxable amount... 20b 21 Other income. List type and amount Combine the amounts in the far right column for lines 7 through 21. This is your total income Educator expenses Adjusted 24 Certain business expenses of reservists, performing artists, and Gross fee-basis government officials. Attach Form 2106 or 2106-EZ 24 Income 25 Health savings account deduction. Attach Form Moving expenses. Attach Form Deductible part of self-employment tax. Attach Schedule SE Self-employed SEP, SIMPLE, and qualified plans Self-employed health insurance deduction Penalty on early withdrawal of savings a Alimony paid b Recipient s SSN 31a 32 IRA deduction Student loan interest deduction Tuition and fees. Attach Form Domestic production activities deduction. Attach Form Add lines 23 through Subtract line 36 from line 22. This is your adjusted gross income For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see separate instructions. Cat. No B Form 1040 (2013) 20 UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL Arch Mortgage Insurance Company

25 Lines 15a, 15b, 16a and 16b 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. N O T E S 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. Arch Mortgage Insurance Company UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL 21

26 Department of the Treasury Internal Revenue Service (99) 1040 U.S. Individual Income Tax Return 2013 OMB No IRS Use Only Do not write or staple in this space. For the year Jan. 1 Dec. 31, 2013, or other tax year beginning, 2013, ending, 20 See separate instructions. Form Your first name and initial Last name Your social security number If a joint return, spouse s first name and initial Last name Spouse s social security number Home address (number and street). If you have a P.O. box, see instructions. Apt. no. Make sure the SSN(s) above and on line 6c are correct. City, town or post office, state, and ZIP code. If you have a foreign address, also complete spaces below (see instructions). Presidential Election Campaign Foreign country name Foreign province/state/county Check here if you, or your spouse if filing jointly, want $3 to go to this fund. Checking Foreign postal code a box below will not change your tax or refund. You Spouse Filing Status 1 Single 4 Head of household (with qualifying person). (See instructions.) If 2 Married filing jointly (even if only one had income) the qualifying person is a child but not your dependent, enter this Check only one 3 Married filing separately. Enter spouse s SSN above child s name here. box. and full name here. 5 Qualifying widow(er) with dependent child 6a Yourself. If someone can claim you as a dependent, do not check box 6a..... Boxes checked Exemptions } on 6a and 6b b Spouse No. of children c Dependents: (2) Dependent s (3) Dependent s (4) if child under age 17 on 6c who: (1) First name Last name social security number relationship to you qualifying for child tax credit lived with you (see instructions) did not live with you due to divorce If more than four dependents, see instructions and check here or separation (see instructions) Dependents on 6c not entered above Add numbers on d Total number of exemptions claimed lines above Income 7 Wages, salaries, tips, etc. Attach Form(s) W a Taxable interest. Attach Schedule B if required a b Tax-exempt interest. Do not include on line 8a... 8b Attach Form(s) 9 a Ordinary dividends. Attach Schedule B if required a W-2 here. Also attach Forms b Qualified dividends b W-2G and 10 Taxable refunds, credits, or offsets of state and local income taxes R if tax 11 Alimony received was withheld. 12 Business income or (loss). Attach Schedule C or C-EZ Capital gain or (loss). Attach Schedule D if required. If not required, check here 13 If you did not 14 Other gains or (losses). Attach Form get a W-2, see instructions. 15 a IRA distributions. 15a b Taxable amount... 15b 16 a Pensions and annuities 16a b Taxable amount... 16b 17 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E Farm income or (loss). Attach Schedule F Unemployment compensation a Social security benefits 20a b Taxable amount... 20b 21 Other income. List type and amount Combine the amounts in the far right column for lines 7 through 21. This is your total income Educator expenses Adjusted 24 Certain business expenses of reservists, performing artists, and Gross fee-basis government officials. Attach Form 2106 or 2106-EZ 24 Income 25 Health savings account deduction. Attach Form Moving expenses. Attach Form Deductible part of self-employment tax. Attach Schedule SE Self-employed SEP, SIMPLE, and qualified plans Self-employed health insurance deduction Penalty on early withdrawal of savings a Alimony paid b Recipient s SSN 31a 32 IRA deduction Student loan interest deduction Tuition and fees. Attach Form Domestic production activities deduction. Attach Form Add lines 23 through Subtract line 36 from line 22. This is your adjusted gross income For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see separate instructions. Cat. No B Form 1040 (2013) 22 UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL Arch Mortgage Insurance Company

27 Line 21 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 N O T E S 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. Arch Mortgage Insurance Company UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL 23

28 Department of the Treasury Internal Revenue Service (99) 1040 U.S. Individual Income Tax Return 2013 OMB No IRS Use Only Do not write or staple in this space. For the year Jan. 1 Dec. 31, 2013, or other tax year beginning, 2013, ending, 20 See separate instructions. Form Your first name and initial Last name Your social security number If a joint return, spouse s first name and initial Last name Spouse s social security number Home address (number and street). If you have a P.O. box, see instructions. Apt. no. Make sure the SSN(s) above and on line 6c are correct. City, town or post office, state, and ZIP code. If you have a foreign address, also complete spaces below (see instructions). Presidential Election Campaign Foreign country name Foreign province/state/county Check here if you, or your spouse if filing jointly, want $3 to go to this fund. Checking Foreign postal code a box below will not change your tax or refund. You Spouse Filing Status 1 Single 4 Head of household (with qualifying person). (See instructions.) If 2 Married filing jointly (even if only one had income) the qualifying person is a child but not your dependent, enter this Check only one 3 Married filing separately. Enter spouse s SSN above child s name here. box. and full name here. 5 Qualifying widow(er) with dependent child 6a Yourself. If someone can claim you as a dependent, do not check box 6a..... Boxes checked Exemptions } on 6a and 6b b Spouse No. of children c Dependents: (2) Dependent s (3) Dependent s (4) if child under age 17 on 6c who: (1) First name Last name social security number relationship to you qualifying for child tax credit lived with you (see instructions) did not live with you due to divorce If more than four dependents, see instructions and check here or separation (see instructions) Dependents on 6c not entered above Add numbers on d Total number of exemptions claimed lines above Income 7 Wages, salaries, tips, etc. Attach Form(s) W a Taxable interest. Attach Schedule B if required a b Tax-exempt interest. Do not include on line 8a... 8b Attach Form(s) 9 a Ordinary dividends. Attach Schedule B if required a W-2 here. Also attach Forms b Qualified dividends b W-2G and 10 Taxable refunds, credits, or offsets of state and local income taxes R if tax 11 Alimony received was withheld. 12 Business income or (loss). Attach Schedule C or C-EZ Capital gain or (loss). Attach Schedule D if required. If not required, check here 13 If you did not 14 Other gains or (losses). Attach Form get a W-2, see instructions. 15 a IRA distributions. 15a b Taxable amount... 15b 16 a Pensions and annuities 16a b Taxable amount... 16b 17 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E Farm income or (loss). Attach Schedule F Unemployment compensation a Social security benefits 20a b Taxable amount... 20b 21 Other income. List type and amount Combine the amounts in the far right column for lines 7 through 21. This is your total income Educator expenses Adjusted 24 Certain business expenses of reservists, performing artists, and Gross fee-basis government officials. Attach Form 2106 or 2106-EZ 24 Income 25 Health savings account deduction. Attach Form Moving expenses. Attach Form Deductible part of self-employment tax. Attach Schedule SE Self-employed SEP, SIMPLE, and qualified plans Self-employed health insurance deduction Penalty on early withdrawal of savings a Alimony paid b Recipient s SSN 31a 32 IRA deduction Student loan interest deduction Tuition and fees. Attach Form Domestic production activities deduction. Attach Form Add lines 23 through Subtract line 36 from line 22. This is your adjusted gross income For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see separate instructions. Cat. No B Form 1040 (2013) 24 UNDERWRITING THE SELF-EMPLOYED BORROWER MANUAL Arch Mortgage Insurance Company