Back in 2015 FNMA opened a discussion that had long been ignored in the industry in regards to borrowers who get K1 income. For years both FNMA and FHLMC had rules requiring lenders to confirm that income used to qualify from K-1’s lines 1,2,3 and cash flow adjustments was supported by the cash distributions received by the borrowers. Before FNMA made the 2015 changes, I would bet if we took a survey of people involved with approving loans, 90% either were not aware of the “how or why” of distribution of income, or just were told to ignore it and use the K1 income without further thought. In my years in underwriting and auditing I honestly can’t recall ever seeing a QC fail or repurchase demand over a borrower not meeting the old stated guidelines about distributions. So, who could blame us an industry for not paying attention to the rules when they were both not taught and not enforced (for the most part!).
Today this topic is now much more known, but there is still a lot of confusion on the “how” of meeting guidelines to use the K-1 line 1,2,3 + Cash Flow Analysis income. Lets start by reading the question or requirement currently in FNMA guidelines.
If the Schedule K-1 reflects a documented, stable history of receiving cash distributions of income from the business consistent with the level of business income being used to qualify, then no further documentation of access to the income or adequate business liquidity is required.
Ok let’s break down this guideline and the steps to answer it, we will start with FNMA since they better explain this concept in their guidelines.
FNMA B3-3.2.1-08 Income or loss reported on IRS Form 1065 or 1120S K-1 (06/28/2016)
The key to these guidelines is following the step and paying attention to the options FNMA allows to use the income. First confirm the business has stable earnings trends (using the same analysis as a FNMA form 1088 would complete). Second after you know the business is stable, then complete a cash flow analysis such as the 1084 or with a tool like www.uber-writer.com offers.
Complete the 1084 and determine the income that your borrower is trying qualify with that comes from the K-1 on lines 1,2,3 plus the cash flow adjustments. Next compare this income to amount of distributions received by the borrower (Distributions are on line 19A for a 1065 and 16D for an 1120S).
This next part is where the underwriter must support one of the options described in Allregs and where most people get confused on the requirements.
Based on the example you can use $22,500, per FNMA guidelines since the cash distributions from the business ($24,000) support the level of business income being used to qualify nothing further is needed.
If the distributions are less than the calculated income use only the supported $10,000 instead of the $22,500 total. This part is very important, using $10,000 does NOT mean that you use distributions to qualify. What using $10,000 means is that the business can NOT support cash distributions of $22,500 of business income to qualify, but can support $10,000 since that is all the borrower received in cash distributions. If you are going to use $10,000 to qualify then nothing further is needed since we have again meet the guideline that states “cash distributions from the business support the level of business income being used to qualify”.
For both options 1 and 2 it is very important to remember we are not replacing the income determined on K-1 lines 1,2,3 and cash flow adjustments with distributions, distributions are ONLY being used to support the qualifying income. Many people teach the technique of ALWAYS using the lower of the two numbers to qualify which is ACCURATE. There is no time that you would just look at the distributions and use that number without comparing to the standard K-1 adjustments, see table below for examples to follow.
FNMA offers a third option when your borrower has K1 income but his K1 shows NO distributions OR the distribution level of income will not get the deal to work (this sentence edited on 07/02/2017). If the borrower business shows it has adequate business liquidity, here is the quote right from the guidelines “But if the Schedule K-1 does not reflect a documented, stable history, then the lender must confirm adequate business liquidity, as discussed below.”
The question you answering here is this, did the business HAVE the funds for distributions and choose NOT to pay out distributions, then you can use your K-1 Lines 1,2,3 + CFA. But if the business did not have the funds to pay out the distributions you cannot use the K-1 Lines 1,2,3 + CFA because the answer is NO the question the guideline is stating “cash distributions from the business support the level of business income being used to qualify”.
The information you need to confirm the question “The business has adequate business liquidity” is found on the business Schedule L for both the 1065 and the 1120S. FNMA provides capital test formulas in their guidelines which we will review in next week’s blog.
Whew…. I know that is a lot of information but if you keep your business income in those three options you will not have an issue at FNMA
A word about FHLMC, the following information is the authors opinion based on 20+ years industry experience and I am very open to debate about this topic.
Before 07/11/2016 FHLMC did have a written requirement about checking a business distributions of income, as of 07/11/2016 they did drop these references and seem to indicate the only time you need to do any “extra” review of business ability to pay is when you are using income OUTSIDE of what the form 91 states to complete. Because the guideline is a bit long to copy here read through FHLMC Allregs 5304.1: Stable monthly income and documentation requirements for self-employed Borrowers (07/11/16) and you can confirm my statements about no references.
BUT FHLMC has posted future guidelines that go in effect on 03/06/2017 and revamp 5304.1. These new guidelines do in fact use many of the same rules and terms that FNMA is now using for K-1 1120S or K-1 1065. Again, this section is long bug if you go to FHLMC Allregs and check under 5304.1 “future revisions” and read down to the new subsection (d) Business and Income Analysis, the information laid out will line up with FNMA current guidelines and my examples above.
To wrap up, this topic was way back in the shadows for years, but now is front and center for your self-employed borrowers who use K1 income from 1065 and K1 income from 1120S to qualify.
SPECIAL ANNOUNCEMENT We will be creating a video explanation this income topic and many more (over 30+ 15 min or less videos) made to show practical examples , supporting guidelines, and our best explanation of the “why behind the what” in our new video teaching library launching in Jan 2017 , keep up with the launch information at our website at www.uber-writer.com for more information.