Overview

Mortgage underwriting determines whether a self‑employed borrower’s income is stable, likely to continue, and sufficient to repay a loan. Unlike wage earners with W‑2s and predictable pay stubs, self‑employed applicants present a mix of Schedule C, K‑1s, corporate returns, profit & loss (P&L) statements, and bank activity. Lenders convert those documents into an “underwriter’s income” figure using program rules, tax‑return adjustments, and judgment about business viability.

In my practice working with self‑employed borrowers, the most common causes of delays are missing schedules, large tax‑reporting adjustments (like big depreciation or owner draws), and unclear cash‑flow documentation. Early preparation shortens underwriting time and improves approval odds.

(Authoritative guidance: IRS resources on small business tax and the CFPB’s mortgage documentation advice are helpful starting points — see Sources.)

Which documents do underwriters want?

Underwriters generally start with the same core set of documents. Most conventional and government‑backed lenders expect at least two years of tax returns unless a specific exception applies.

  • Personal federal tax returns (Form 1040) for two years, with all schedules (Schedule C, Schedule E, Schedule F, etc.).
  • Business tax returns if the business is a separate legal entity (Form 1065 for partnerships, Form 1120S for S corps, Form 1120 for C corps).
  • Year‑to‑date profit & loss statement (P&L) and balance sheet prepared by the borrower or CPA.
  • Bank statements (personal and business) — typically 2–12 months depending on the program.
  • K‑1s (Schedule K‑1) for income passed through from partnerships or S corporations.
  • Evidence of business continuity: invoices, contracts, client letters, and business licenses.
  • Explanation letters for one‑time events (large losses, one‑time income, pandemic impacts).

If you use a bank‑statement loan program, lenders may replace tax‑return calculations with 12–24 months of bank deposits to calculate qualifying income (see program differences below).

How do underwriters calculate qualifying income?

Underwriters use program rules to convert reported income into qualifying monthly income. Common steps include:

  1. Confirming two‑year history. Lenders generally prefer a two‑year track record showing stable or rising income. If the borrower has less than two years, many lenders require additional documentation (current P&L, CPA letter, or evidence the business was acquired).

  2. Averaging income. For Schedule C or K‑1 income, underwriters typically average net income across two years. If one year shows a significant drop or a one‑time spike, lenders will often average both years (example: $80k one year, $50k next = average $65k).

  3. Adding back non‑cash deductions carefully. Depreciation and depletion on tax returns are non‑cash items; some programs allow repositioning those back into income, while others do not. Common permitted add‑backs include depreciation, amortization, and owner‑only health insurance in certain cases — but policies differ by investor (Freddie Mac, Fannie Mae, FHA).

  4. Adjusting for owner compensation. For corporations, underwriters look at reasonable owner salary plus distributions. If owners take minimal W‑2 salary and large pass‑through income on a K‑1, lenders will scrutinize sustainability and may require documentation of recurring distributions.

  5. Considering discretionary expenses and one‑time losses. Large owner draws or related‑party expenses can reduce qualifying income. Lenders will request explanations and sometimes add those amounts back if properly documented.

  6. Using bank statement deposits. For bank‑statement programs, lenders calculate average monthly deposits (often smoothing seasonal income) and subtract business expense estimates. This is common for borrowers who legitimately reduce taxable income through deductions.

Always remember: specific calculations vary by loan product and investor guidelines.

Loan‑program differences that matter

Different mortgage programs treat self‑employed income differently. Expect variance in required documentation, reserve requirements, and acceptable add‑backs.

  • Conventional (Fannie Mae / Freddie Mac): Typically require two years of tax returns. Both agencies publish guidelines on treatment of Schedule C and K‑1 income; lenders must follow investor overlays in addition to agency rules.

  • FHA: Allows more flexibility on credit scores and down payments but still generally requires two years of tax returns for self‑employed income. FHA underwriting may be more permissive on reserves in some cases but still requires evidence of ability to repay.

  • VA: Requires two years of income documentation for self‑employed borrowers and emphasizes stability and continuation of income.

  • Bank‑statement and stated‑income alternatives: Designed for those with significant deductions or nontraditional reporting. These programs use 12–24 months of bank deposits to compute qualifying income, but rates and down‑payment requirements are often higher.

Because guidelines shift and lenders add overlays, always check the specific program rules before applying.

Red flags and common underwriting adjustments

Underwriters look for signals that income may not continue. Common red flags include:

  • Sharp recent declines in revenue without a documented recovery plan.
  • Large non‑recurring business income that inflated one year (e.g., sale of equipment, legal settlements).
  • Excessive write‑offs that leave little tangible cash flow.
  • Missing or unsigned tax forms and unsupported Schedule C expenses.

Common adjustments underwriters make:

  • Using a multi‑year average when income spikes or dips.
  • Adding back certain non‑cash deductions on a case‑by‑case basis.
  • Requiring cash‑reserve buffers (varies by program; six months is a conservative target).

Practical checklist to prepare before you apply

  • Gather two years of complete federal tax returns (signed) with all schedules.
  • Get corporate returns and K‑1s if you have a pass‑through entity.
  • Prepare a current year‑to‑date profit & loss (ideally CPA‑prepared) and bank statements.
  • Update or create a written list of recurring clients or contracts and any upcoming signed work.
  • Work with a CPA to document any add‑backs you’ll request (depreciation, amortization, non‑recurring items).
  • Build reserves: aim for 3–6 months of mortgage and business expenses; more if your income is volatile.

Real examples (anonymized)

  • Freelance designer: Two years of Schedule C showed $48k and $62k. By averaging and adding back a small depreciation entry with CPA documentation, the borrower qualified for a conventional loan.

  • Consultant with S‑Corp: Minimal W‑2 salary but $120k in K‑1 distributions. Lender required proof of consistent distributions and a letter from the CPA confirming recurring income before qualifying.

  • Restaurateur (seasonal dips): Bank‑statement program helped by using 18 months of deposits to smooth seasonal peaks and troughs; resulted in a higher rate but approval where conventional underwriting would have denied.

Common misconceptions

  • “If I show one strong year I’ll qualify.” Lenders generally average multiple years, and one good year rarely overrides a weak year.
  • “All tax deductions are ignored.” Some non‑cash deductions can be added back; others are scrutinized. Always discuss with a CPA.
  • “Bank statements are always better.” Bank‑statement loans help some borrowers but come with higher cost and stricter documentation of business legitimacy.

FAQs (short)

  • How much history do I need? Usually two years of returns; exceptions exist for new businesses with strong documentation.
  • Do I need reserves? Most lenders require proof of reserves; a conservative personal target is 3–6 months of mortgage and business expenses.
  • Can I use projected contracts to qualify? Lenders may consider signed future contracts as additional evidence, but they prefer historical income.

Next steps and resources

If you’re self‑employed and thinking about a mortgage, prepare tax years thoroughly and speak with a mortgage professional early. A CPA can cleanly document add‑backs and a mortgage broker can match you to lenders familiar with self‑employed file review.

Further reading on FinHelp:

Professional disclaimer: This article is educational and not personalized financial advice. Consult a licensed mortgage professional and your CPA for guidance specific to your situation.

Sources