In the Introduction, we discussed the various types of business you may see when underwriting and documenting for a self-employed borrower. In this learning clip, we will focus on a sole proprietorship.

Please remember that you are responsible for determining if your borrower’s income documentation demonstrates that he or she will have the financial ability to repay the mortgage.

The following chart describes the tax reporting information and advantages/disadvantages of a sole proprietor.

The following is a helpful scenario to help you understand how to determine how to qualify a self-employed borrower in a sole proprietor business type situation.

Bob's tax returns in a sole proprietorship are provided for further clarification.

Here is a copy of Bob’s W-2. You will need to validate the income and employment information on his application and what you submitted to Loan Prospector is accurate. This would include:

• Confirm box 1 matches with line 7 of his individual tax return
• Confirm the name, address and social security number is the same as shown on the loan application and tax return

Let's take a closer look at Bob's tax returns:

• Bob has $48,892 in W-2 income from Home Express. We already reviewed the W-2 to validate these earnings.
• Bob shows interest and dividends on line 8A and 9A which requires Schedule B. If you intended to use the interest and/or dividend income for qualification, you would need to verify the existence of the funds supporting this income.
• In addition, you would need to determine Bob has sufficient assets without these funds for the transaction. If he will be using these funds for closing, the income cannot be expected to continue and must be deleted from your totals.
• Line 11 shows alimony of $12,000 received. Before considering this income for qualification purposes, you would need to determine the source and if it will continue for at least the next three years. Documentation required would be a copy of the appropriate pages of the court document and evidence of receipt for 3 recent consecutive months.
• Line 12 represents Schedule C income of $15,313 from the business. [To play movie, click right blue arrow below]

For the tax return to be acceptable to Freddie Mac, it does need to be signed and dated by the borrowers.

Schedule A shows itemized deductions. Bob shows he pays mortgage interest of $9,980.00. While a tax return answers questions, it can also create them. Your job in analyzing the tax returns is to validate the information they are intended to support as well as close any gaps or questions the return may create.

Bob declared interest and dividends on page one, so Schedule B should reflect more information on where the interest and dividend income is coming from. You will need copies of his 1099(s) to validate these numbers.

Schedule C is where Bob reported his income from Pine Island Electric, a company which Bob owns 100%.

• When reviewing a Schedule C, start with line 31 and work your way backward. You can 'add back' the deductions listed on Schedule C from deprecation/depletion and amortization.
• Depreciation is the loss of value of an asset due to normal wear and tear. Assets include items such as real estate, machinery, furniture and even vehicles. 'Add back' to income any depreciation reported on Schedule C.
• Depletion is the using up of natural resources or inventory. Examples are coal, timber, gas, oil. You can 'add back' all depletion.
• Amortization expenses are also 'add backs' as they are usually one time costs that are distributed over a period of time and can therefore be added back to total income. Documented non-recurring losses such as casualty losses and loss carry-overs from previous years may also be added back. Keep in mind it may be difficult to determine the stability of a business which has been in existence for less than 2 years unless the borrower has a previous history of successfully managing a business that can be documented.
• If your borrower reports that an auto loan on his credit report is actually paid by the business, you should be able to help validate that with Schedule C. Line 9 should reflect an amount equal to or great than the annualized payments of the auto loan.

Part III of Schedule C shows Cost of Goods Sold and Bob's inventory at the end of the year. You can see he increased his inventory. Does that mean he has expanded his business? This may explain a temporary decrease in income.

Form 4562 is the supporting document used any time depreciation or depletion is indicated on Schedule C. These figures should match the information on Schedule C. If not, you should be concerned that Bob could have provided you with fraudulent or altered returns.

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