underwriting for self employed borrowers freddie mac

An Overview of Freddie Mac’s Requirements for Self-employed Borrowers

December 2009 2

How to participate via the Internet (WebEx)

Using your feedback toolbar

To ask a question

Using your floating icon tray

For Technical Support, call (866) 229-3239

Tools and Tips

December 2009 3

ObjectivesTo help you understand Freddie Mac’s requirements for:

Determining who is a self-employed borrower

Analyzing the different types of self-employed income

Documenting the income for a self-employed borrower in the mortgage file

To provide you with tips and tools you can use to to enhance your processes and successfully underwrite self-employed borrowers

December 2009 4

AgendaSelf-employed borrower risk and Seller responsibilityFreddie Mac’s definition of a self-employed borrowerTypes of businesses that need to be analyzedRequirements for analyzing the business and incomeMortgage file documentation requirementsLoan Prospector® data requirementsResources

December 2009 5

Because a self-employed borrower is typically at greater risk for defaulting on a loan than an employed borrower for various reasons.

Why is more analysis required for a self-employed borrower?

Self-employed Borrower Risk

December 2009 6

Freddie Mac looks to you to determine that the self-employed borrower demonstrates the financial ability to repay the mortgage.

Seller Responsibility for Self-employed Borrowers

An essential step to determine whether you can reasonably expect the borrower to repay the mortgage as agreed, is a careful evaluation of the:

Borrower's income, andBorrower’s employment history

December 2009 7

What do you need to know?Who is a

self-employed borrower?

What are the Loan Prospector

data requirements?

Is the business

financially sound?

What documentation do

you need in the mortgage file?

What’s required for the income

analysis?

Is there stable monthly

income?

What types of businesses

need to be analyzed?

December 2009 8

Guide Section 37.13 (b) states…

A Borrower who has an ownership interest of 25% or more in a business is considered to be self-employed.

Who is a self-employed borrower?

Regardless of how much the business contributes toward their total income

December 2009 9

Income Exercise - MaryIf Mary owns 33 percent of a small family-owned pastry shop, but is employed full-time as an accountant and doesn’t need the income from the family business to qualify, do you need to analyze her tax returns?

a) Yes

b) No

Why or why not?

December 2009 10

There are three basic business types with variations you need to analyze:

Sole ProprietorshipPartnership (General and Limited)Corporation

GeneralS-CorpLimited Liability (LLC)

What are the various types of business structures that need to be analyzed?

December 2009 11

Sole ProprietorshipBusiness owned by one ownerEasy and inexpensive to establishIncome is reported on Schedule C of Form 1040Income is taxed at owner’s personal tax rate

Tax Returns You’ll Need to Analyze

Form 1040, Individual Tax ReturnForm 1040 Schedule C, Profit or Loss From Business

Business income is taxed at personal rateTypically considered a more risky business classification due to owner’s unlimited personal liability for all business lossesTypically unable to raise large sums of money for reinvestment

December 2009 12

General and Limited PartnershipsBusiness owned by two or more partners

Income reported on Form 1065(income is carried forward to Form 1040 via Schedule K-1)

Owner’s income is reported on Part II of Form1040 Schedule EAll income is passed through to partners who pay at personal rate, partnerships pay no tax


Form 1040, Individual Tax ReturnForm 1040 Schedule E, Supplemental Income and LossForm 1065 Return of Partnership IncomeForm 1065 Schedule K-1, Partner’s share of Income, Deductions, Credits, etc.

Advantages: Resources of money, skill and labor can be pooledDifference between General and Limited Partners:

General partners have unlimited personal liability for all partnership debts and lossesLimited partners are liable only for the amount they invested

December 2009 13

Corporation (General)No limit to number of shareholdersIndividual income is reported by W-2’sCorporate income is taxed at the corporate rateShareholders are not personally liable for the corporate debtsDouble taxation may occur


Form 1040, Individual Tax Return with any applicable W-2s Form 1120, Corporation Income Tax Return

December 2009 14

S-CorporationCan have up to 75 shareholdersS-Corp files Form 1120SShareholder’s income is reported as a distribution via K-1 on Schedule E of Form 1040The S-Corp pays no tax on income; all income is passed through to its shareholders


Form 1040, Individual Tax ReturnForm 1040 Schedule E, Supplemental Income and LossForm 1120S, Income Tax Return for an S CorporationForm 1120S Schedule K-1, Shareholder’s share of Income, Deductions, Credits, etc.

Main advantage is no double taxationLimited number of shareholders can make raising capital difficult

December 2009 15

Limited Liability Company (LLC)First introduced in the US in 1988 as a “pass-through status”Advantages:

Flexibility in organization and managementProtection of personal assets from business debtsTaxed at personal levelAre not restricted like S-corporations, which makes them attractive to foreign investors


Will depend on setup of tax entity; typically like a partnership:

Form 1040, Individual Tax ReturnForm 1040 Schedule E, Supplemental Income and LossForm 1065 Return of Partnership IncomeForm 1065 Schedule K-1, Partner’s share of Income, Deductions, Credits, etc.

Disadvantages:Limited life spanEach state has number of membership requirementsSince they are not considered a corporation, they can not have benefit of stock ownership or sales

December 2009 16

Business Type

No. of Owners

Where is business income reported?

Where is owners' income

reported?

Taxation of business income Main Advantage Main Disadvantage

Sole Proprietor

One Schedule C of Form 1040 (no separate business return)

Schedule C of Form 1040

Income is taxed at owner's personal tax rate.

Easy and inexpensive to form. Business income is taxed at personal rate.

Unlimited personal liability for the business and for losses. Typically unable to raise large sums of money to invest in the business.

PartnershipGeneralLimited

Two or more partners

Form 1065 (income is carried forward to Form 1040 via Schedule K-1)

Part II of Schedule E on Form 1040 (via K-1 withdrawals and distributions)

Partnership pays no tax on income; all income is passed through individual partners who pay tax on income at personal rate.

Pooling of resources: money, labor, and skill. Partnership income is taxed at personal rate. Limited partners are liable for partnership debts and losses only to the amount invested.

General partners have unlimited personal liability for partnership debts and losses.

Corporation No limit on number of share-holders

Form 1120 Wages line of Form 1040 or their W-2

Corporate income is taxed at corporate rate. If this income is paid to share holders as dividends, the share holders pay tax on it at personal rate.

Shareholders are not personally liable for the corporation's debt. Easy to transfer ownership (sell shares of stock).

Double taxation issue: corporate income is taxed at corporate rate. If income is paid to shareholders as dividends, this income is again taxed at their personal rate.

S-Corp(Combination of partner-ship & corporation)

Up to 75 share-holders

Form 1120S Part II of Schedule E on Form 1040 via K-1 (distributions)

S-corporation pays no tax on income. All income is passed through to individual share-holders who pay tax on income at their personal rate.

S-corporation pays no tax on income. All income is taxed at individual shareholders' personal rate. No double taxation.

No more than 75 shareholders; limits the raising of capital from a large number of investors.

LLC(Limited Liability Company or Corporation)

No limit on number of share-holders

The forms necessary for filing as an LLC depend on the type of federal tax entity that is either elected or defaulted to. Most LLCs with more than one member file a partnership return, Form 1065.

Part II of Schedule E on Form 1040 via K-1 (distributions)

All income is passed through to individual shareholders who pay tax on income at their personal rate.

Combines the limited liability protection of a corporation and the pass through taxation of a sole proprietorship or partnership.

Forming an LLC is more expensive than a partnership or a sole proprietorship. Does not offer the free transferability of owner-ship, perpetual existence, and the ability to be totally owned by a single individual that one gets with a corporation. State statute frequently limits the life span of an LLC to less than 30 years. If maintained beyond that, the IRS may consider it to be a corporation.

December 2009 17

Business Types – Where’s the Greatest Risk?A sole proprietorship is typically considered to be more risky due to owner’s unlimited personal liability for all business losses

A corporation is often the least risky because the owner is not personally liable for the company’s debt

General partners also carry personal liability for all partnership debt and losses

December 2009 18

Stable monthly income (qualifying income) is the borrower’s gross monthly income from all verifiable sources that is reasonably expected to continue for at least the next three years. In order to consider the income stable, the borrower must have a two-year history of receipt, in most instances.

Is there Stable Monthly Income?

The determination that the income is expected to continue must be based on:

OccupationTenurePast employment history, and Probability of consistent receipt

The existence of the business must be verified by a third party source no more than 30 days prior to the Note Date

Guide Section 37.13

December 2009 19

If Less Than a Two-year History…Document the Borrower has a two-year history of receipt of the income at the same or greater level, in the same or a similar occupationConsider the Borrower's experience in the business before considering the income for qualifying purposesConsider the acceptance of the company’s service or products in the marketplaceVerify Borrower's individual federal tax returns reflect at least one year of self-employment income

Guide Section 37.13 (b)

December 2009 20

Income Exercise – Teresa and DanTeresa and Dan are looking to use their combined income to qualify for a mortgage. Dan has been employed as an engineer in a small firm for the last six years. Teresa startedher own travel agency business 18 months ago. Before this, she was employed as a manger in a grocery store chain. Her business is set up as a sole proprietorship and made a small profit her first year. Things are going well, and her second year looks to be even more profitable than her first.

Can you use Teresa’s income to qualify?

December 2009 21

If Relocating to a Different Geographic Area…

Consider the acceptance of the company's service or products in the marketplace before considering the income for qualifying purposesDocument and explain how you determined that the Borrower's income will continue at the same level in the new location


December 2009 22

Is the business financially sound?Use caution when including additional income drawn from the Borrower's corporation, partnership or S-corporation as qualifying income

Analysis of the business must support the business is clearly capable of providing the Borrower with the additional income used to qualify


December 2009 23

If using additional income from the business…Verify:

The Borrower has legal right to additional income. For example, obtain a corporate resolution or other comparable document establishing the legal right

The Borrower’s percentage of ownership of the business entity from a review of the business tax returns, letter from the accountant for the business or similar documents


December 2009 24

What are Freddie Mac’s expectation for determining stable monthly income?

Review complete individual, and business tax returns if applicable, to determine qualifying monthly income

Complete a written income analysis of how you determined the qualifying monthly income using Form 91, or a comparable form


December 2009 25

Example of a Written Income Analysis Tool

Income Analysis Form 91 available

Tool to help determine self-employed income Does not replace full analysis of the business

December 2009 26

Instructions for Income Analysis Form 91

Provides line item direction for completing analysis Separate forms should be used for each borrower to complete analysis

Example of a Written Income Analysis Tool

December 2009 27

When Analyzing the Business, Consider…The ability to add back certain items on tax returns to the adjusted gross income when determining qualifying income such as:

Depreciation Depletion AmortizationDocumented nonrecurring losses, such as casualty losses or carry-overs from previous years

Income increases or decreases over the previous two years – what is the income trend?


Note: If using business assets for down payment, financing costs, prepaids/escrows and closing costs, the assets must be:

Verified in accordance with Guide Sections 37.20 - 37.23Related to the business the borrower owns and documented in the mortgage file

December 2009 28

If income decreases, focus analysis on the most recent earnings and income most likely to be received to be received at the level used for qualifying

If income increases and using the higher income to qualify, obtain sufficient documentation to determine that the increase is stable and likely to continue at the level used for qualifying

Income

Income Trend – Are there Significant Increases or Decreases in Income Level?


December 2009 29

If You Are Not Using the Income to Qualify…You still need to obtain the Borrower's individual federal tax returns to determine if there is a business loss that may have an impact on the stable monthly income used for qualifying


If a business loss is reported, you may need to obtain additional documentation in order to fully evaluate the impact of a business loss on the income used for qualifying, so you can make a determination about the borrower’s financial ability to repay the mortgage

December 2009 30

What documentation do you need in the mortgage file?

Tax returns for the two most recent years*Signed 8821, 4506 or 4506-TVerification of existence of the business from a third party source no more than 30 days prior to the Note DateIncome Analysis on Form 91, or similar formWritten Analysis of your conclusion on Form 1077, or another document

*Unless Loan Prospector returns a Streamlined Accept documentation level requiring one year of tax returns and you can otherwise document a two-year history of incomeNote: In lieu of tax returns, Form 8821, 4506 or 4506-T from the IRS is acceptable, provided all line items are obtained

Guide Section 37.13 (b), 37.22 and 37.23

December 2009 31

Written Analysis Requirement

For example:1077 Underwriting Comments Section

Must include written analysis of the income used to qualify the borrower in the mortgage file.

“An income analysis of Mr. B’s last two tax returns show an average monthly income of $3,000 from his consulting business. Mr. B has been in the same line of work for the past ten years and self-employed for the last four years. Analysis of the business reflects stable growth for the last two years that’s projected to continue into the foreseeable future. Assets are strong, with little debt. The business appears financially sound overall, and ….”

December 2009 32

Loan Prospector Documentation Matrixwww.FreddieMac.com/learn/pdfs/uw/docmatrix.pdf

December 2009 33

Income Exercise - Marion

Marion has owned his own landscape business for the last 5 years. The business operates as a sole proprietorship. According to his tax returns, Marion's income, after adding back noncash expenses, was $28,000 last year and $32,000 for the previous year.

1. Would you consider this to be an example of stable monthly income?

2. How would you determine monthly income?

December 2009 34

1. Indicate self-employed for each borrower who has 25% or more ownership in a business, regardless if the income is used to qualify

2. Enter the total amount of self-employed income used for qualifying*

3. Include the amount of self-employed income in the total monthly income*

What are Loan Prospector’s data requirements?

*If using the Monthly Income Breakdown, enter the amount of self-employed income in an appropriate field so Loan Prospector automatically includes the self-employed income in the Monthly Income total

3.

2.

1.

December 2009 35

Shawn manages a sporting goods store earning $4,500 per month. For the last several years, he’s owned a small tree trimming business. His tax returns from the previous two years indicate this business has been providing him with an average of $1,000 of additional income per month. How would you enter Shawn’s employment information in Loan Prospector if:

1. Using Shawn’s income from the tree trimming business to qualify?

2. You determined the tree trimming business income wasn’t stable enough to use?

Loan Prospector example

1.

2.

December 2009 36

1. Determine your borrower’s ownership interest in the business(es)

2. If 25% or more ownership interest, indicate self-employment in Loan Prospector or manually underwrite as self-employed

3. Obtain the documentation required by Loan Prospector’s documentation level, or the Guide if manually underwriting

4. Analyze the documentation to ensure financial stability exists (additional documentation may be required if unable to determine stability with minimum documentation

5. Obtain signed IRS Form 8821/4506/4506-T 6. Provide a written summary on your analysis of the business on

Form 1077 or similar and include your income analysis showing how the income was calculated

Recap – Reminders for Responsible Lending

December 2009 37

Freddie Mac’s Single-Family Seller/Servicer Guide Chapter 37Your Freddie Mac Representative1-800-FREDDIEwww.IRS.gov/Mortgage Insurance Company resources

Additional Resources

December 2009 38

The Learning Center Updates page provides quick access to new and updated resources to help you with underwriting, mortgage products, selling, servicing, and more.

View a summary of recent changes at www.FreddieMac.com/learn/ch_ind/

www.FreddieMac.com/learn/subscribe

Receive a timely email informing you of new and updated training and education resources.

It’s a notification that’s not just another email in your inbox!

atAlso FREE!Subscribe!

Learning Center Updates

http://www.freddiemac.com/learn/ch_ind/

http://www.freddiemac.com/learn/subscribe

December 2009 39

Questions?

Please complete post-session survey that appears to the right of this slide

December 2009 40

Thank you for your participation!

NoticeThis document is not a replacement or substitute for the requirements set forth in the Freddie Mac Single-Family

Seller/Servicer Guide (Guide) and/or terms of your Master Agreement and/or Master Commitment.

underwriting for self employed borrowers freddie mac

Documents