NOTICE: Due to regulation changes the content of this article is no longer current.
For years FNMA’s guidelines for self-employed borrowers who receive income on the K-1 form (either 1065 or 1120S business types) was at best loosely followed. The guidelines required that if you were using income from lines 1, 2, 3 and cash flow adjustments the underwriter was required to take this next step (this is the part that has been loosely followed). The underwriter was to document a stable history of receiving regular cash distributions from the business consistent with the level of business income being used to qualify
Where are distributions going for FNMA?
Full disclosure, this next statement is not an official statement but I have heard from several independent sources that FNMA is going to crack down on proper evaluation of the K-1 income with all mortgage applications dated February 1st, 2016 and later.
So the next question is “ok what does properly evaluating K-1 income mean and how do I qualify borrowers on distributions or ordinary income?” After talking to several respectable sources and reviewing the FNMA guidelines (B3-3.2.1-08 in FNMA Allregs), here is the best practices I found to help answer that question for you and your company.
Evaluate K-1 income with the following steps:
1) Using a cash flow analysis form (CFA) total the income from the K-1 lines 1, 2, and 3. Special note guaranteed payments on the 1065 line 4 and W-2 wages for both business types are separate income and are not affected by distributions.
2) If the borrower has 25% or greater ownership complete the business adjustments on the CFA and add that total to the K-1 income from step 1.
3) Compare the total on step 2 to the distributions on the K-1 (1065 Line 19a and 1120S Line 16D) if the ordinary income is at least equal to the distributions then use the ordinary income on the CFA. Per FNMA nothing further is needed here in regards to documentation.
4) If the distributions are lower than the ordinary income here are a few options to consider
a) Use the distribution number instead of the ordinary income number (in other words you are using the lessor of ordinary income versus distributions) no further documents will be required.
b) If the borrower will not qualify on the lower distribution number and you need to use the ordinary income number follow these steps. You will need document two things, first that the borrower does have access to the income, and second the business has adequate liquidity to pay that income.
Step 4b is where things become risky, there is no current guidance from either agency on what is exactly acceptable for documentation for access to the funds, or what is acceptable to prove the business has adequate liquidity. One suggestion I can offer on adequate liquidity is to use a standard solvency test, if the business can show acceptable solvency after paying out the ordinary income that would seem to indicate the business had adequate liquidity to pay the distributions.
I hope this blog has helped provide some options on how to handle the distributions. I would like to hear from you on best practices on evaluating K-1 income. Please leave some comments on your process, insight, or ideas.