I have been writing blogs for UberWriter since 2013 on many different underwriting topics. While putting together some training information I realized that I have zero blogs about P/L’s in all six years! I was pretty surprised by that statistic since the question of P/L’s comes up quite a bit between April and October mainly for self-employed borrowers who have extended their tax filings.
What I wanted to do on this blog is to provide some basics about the “what, why, and how” of using P/L’s for income in the mortgage business. Most of the questions people call or send in asking about this topic would be covered in this “ Profit & Loss 101”
What are profit and loss statements?
This statement shows revenues and expenses of the business, and resulting profit or loss, over a specific time period (a month, a quarter, or a year). Every business should prepare and review its profit and loss statement periodically – at least every quarter. Reviewing the profit and loss statement helps the business make decisions and to prepare the business tax return. Your business tax return will use the information from the P&L as the basis for the calculation of net income, to determine the income tax your business must pay.
How are profit and loss statements used in the mortgage business?
The main purpose of a profit and loss is to confirm filed business income with the IRS is stable or increasing since the last tax filing. Depending on what agency you use, this could be a short as one quarter since filing (for FHA loans).
The mistake most people make is they want to use the P&L in the same way you use a tax return, bottom line, unaudited P&L’s are not allowed to be used for income calculation. These forms are only used to support the tax returns.
The next question I get is “Why can’t you unaudited P&L’s as income?”, the simple answer is you don’t have a trusted source… if the borrower is providing it how do you know it is accurate? They might just be a bit biased when they want to get a loan right? When the borrower files tax returns to the IRS you know they did their best to be accurate to avoid getting audited and fined by the IRS. The agencies all want the lenders/sellers to be sure that the information is accurate and verifiable, and P&L’s just don’t meet those standards.
Note on Audited Profit & Loss Statements: FHLMC, FHA, and VA allow the use of Audited P&L or Quarterly Filed tax returns to be used for income calculations, in addition to the primary function of supporting stability from previous years. From my research and experience, I have not found that Fannie Mae or USDA allows an audited P&L’s to be used for income.
How to review the profit and loss statement
There is no mandated form for P&L, however most P&L’s are laid out much like a schedule C. See our example below for a full year P&L. The requirement for the underwriter is to translate the taxable income to spendable income, this process is done using the same add and subtract rules as you would with a Schedule C business.
Using this example, here is how the math will work
$85,000 Gross Profit
+ $38,000 Depreciation
= $123,000 Business Adjusted Business Income
**NOTE if the P&L is less than a full year you will need to annualize the income.
Analyzing the Results
Now that you have the adjusted business income the next step is to use that income to compare it to the last tax year filed. The goal here is to confirm the business income is stable and consistent. You ask the following questions when reviewing:
- Are the gross sales YTD in line with the last filed business return?
- Are the overall expenses and cost of goods sold, in line with the last filed business return?
- Are the net profit figures in line with the last filed business return?
By answering these three questions about the business you can reasonably determine if the borrowers’ personal income earned from any business type is stable between the current time and the last tax filing, this works on all SE types. (Sch C, Sch F, 1065, 1120S, and 1120).
Hopefully this P&L 101 gives you some basic direction on the “What, why, and how” of using P&L’s in the mortgage business. If you would like more detailed training on this topic or underwriting in general check out our online classes at www.uwfieldguide.com!