Can a borrower use K-1 income with less than 25% ownership?
Recently we have received some questions about if a borrower can use income they get from a K-1 when they have less than 25% ownership. To best answer this we need to break down the elements of getting a K-1 and what the mortgage agencies (Fannie / Freddie / FHA/ VA / USDA) say or don’t say about this type of income.
First, let’s consider when the source of K-1 income is partial ownership of a partnership (1065 K-1) or an S Corporation (1120S K-1). These are pass-through business entities that when they make a profit or loss, the person who gets the K-1 will reflect that profit or loss on their Schedule E under the business ownership section.
The concept of business ownership is where the confusion seems to arise in the mortgage industry. The mortgage business clearly defines self employed at 25% or greater ownership in any business entity. But the IRS does not make that difference, what they care about is: Did you earn any income (or loss) whether you own 1% or 100% of a K-1 business.
This is where things get gray in the guidelines, and the following is part guidelines (which I will point out) and part best practices (my suggestion).
To get back to the original question, can you use income from a K-1 < 25%? YES!!
The guidelines for (of any type) require four things:
- The income must reasonably continue for 36 months
- The income must be stable to qualify
- The income must have a proper history (in this case 2 years)
- The income must be documented
Let’s start with what we do have as a foundation from Fannie Mae
B3-3.1-09, Other Sources of Income
In that section it states that income from K-1 can be used if:
- It is from K-1 Line 1 Ordinary Income , Line 2 Net Rental Income , Line 3 Other Rental Income
- There is evidence of liquidity (the K1’s show distribution of the income)
- There is a two year history of the income
What the guidelines don’t say is that you can use business cash flow adjustments such as depreciation, depletion, or one time expenses. This is a point where most of the disagreement comes.
The next few statements are my opinion and feel free to disagree, but I want to lay out how I came to these conclusions and consistently underwrite and teach in the manner I do.
If the borrower is not self employed don’t use these adjustments because per the agency’s guidelines only reference using those adjustments for self employed borrowers, which under 25% ownership is not. When a borrower is less than 25% owner, the theory is they have much less control over company finances (and direction) then if they were over 25%.
For example, would it be reasonable to believe that if you were 20% owner of a business, and wanted to buy a home, that you could tell the other owners that you are going to pull out x-number of dollars from the company checking to pay the down payment? I mean after all, that depreciation write off is just tax based so I want my 20% of that number to help pay my mortgage!
I think it is safe to assume…. Probably not!! I have had discussions with underwriters who say , “but these guidelines state you can add back depreciation”… While that is true, in real life those funds are stored in company accounts to save up and buy equipment. I don’t think the other owners would look kindly on emptying the war chest to buy wants not needs that are not company related. And where would that kind of control stop? Could someone who owns 4% use the depreciation as income?
Again, fully admitting that using K-1 income with less than 25% ownership is gray, but whatever stance you take on this income as an underwriter or a person writing policy you should be able to articulate it and defend it with an investor.
Now what other guidelines can I reference? The answer is NONE, I don’t see any other references. With that being said for Freddie , FHA, VA, USDA here is a snapshot of how I would handle these:
Follow the same rules as Fannie, since they are both regulated by the FHFA they tend to have the same rule sets. Where the danger lies is we all know even though they are both regulated by FHFA they do have different rules about different topics that can not be violated. So if you need the K-1 < 25% or under income stick with Fannie Mae if at all possible.
These government sponsored programs tend to be very conservative in their approach to income. Based on that I would not use the K-1 < 25% income here. In my experience with all three agencies, if you call them and ask about things not in the regulations, they tend to tell you no because they have no supporting evidence. I have seen many audits come back that underwriters took some conforming liberties with the government agencies.
I hope this blog has given some insight, things to question, and possibly inspire your company to write a white paper on what your underwriting department will do when they come across situations that are not clearly addressed in the guidelines (which are more than people think!)
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